Handled correctly, an inherited traditional individual
retirement account can be a tidy windfall. But if you don't follow
IRS regulations to a "T," you could end up paying significant
penalties and taxes.
Inheriting a traditional IRA provides you with the
unique opportunity to continue tax-deferred investing. Over time,
that tax advantage can dramatically increase the value of the inheritance.
That's the good news. The bad news is that IRS rules
for making the most of the tax advantages that come with inherited
IRAs -- finalized last summer -- run about 45 pages long and the
caveats are as dense as trees in the Black Forest.
Tax ramifications of inherited IRAs is a relatively
new topic. The first IRAs, now known as traditional IRAs, were introduced
only 30 years ago and only in the past few years have baby boomers
started receiving IRAs as part of an inheritance.
Roth IRAs can also be inherited, but are subject to
slightly different IRS rules. More about that later.
Inheriting an IRA from a spouse is simpler than inheriting one from
someone else, such as a parent or elderly aunt. A spouse also has
special privileges that aren't available to non-spouse beneficiaries.
A spouse can:
- Roll it over. A spouse can simply roll
over the account into his or her own existing or new IRA account
and can continue contributing to it. Non-spousal beneficiaries
cannot roll over inherited IRA funds, nor can they add money to
an inherited account.
- Remain a beneficiary. In this case the IRA
is transferred to a beneficiary distribution account, also called
a beneficial or inherited IRA. The deceased person's and the beneficiary's
names both remain on the account. The beneficiary distribution
account, can be advantageous if the surviving spouse is younger
than 59 1/2 but wishes to tap funds from the IRA without paying
a 10-percent early-withdrawal penalty. The beneficiary distribution
account, can also be a good option if the surviving spouse is
much older than the deceased spouse.
- Cash out the account. This move could have
serious tax implications. It's wise to talk to a tax professional
before taking this extreme step.
- Disclaim or give away an inherited IRA.
If you're doing well financially you might choose to give your
inherited IRA to someone else -- your child, for example -- so
the account can grow tax-deferred over a lifetime. This option
should be discussed with the original IRA account holder while
he or she is still living. You may also need to seek legal advice.
By choosing either the rollover or the beneficiary
distribution account, a spouse can defer taking funds out of the
IRA until reaching age 70 1/2, the point at which annual required
minimum distributions begin. This deferral option often is a great
bonus for younger surviving spouses. By contrast, non-spouses can't
totally defer required minimum distributions. For further details
on spousal inheritances, consult your tax professional. The rules
and tax implications are (surprise!) complex.
If you inherit an IRA from someone other than a spouse, you cannot
treat it as just any other IRA. It's a totally different animal.
"A spouse who inherits an IRA is the only person
who can commingle funds with other IRAs," says Marsha Goetting,
Ph.D., CFP, CFCS, a professor and extension family economics specialist
at Montana State University. "Everyone else must keep inherited
IRAs totally separate and may not make new contributions to these
So, if you think you might inherit an IRA from someone
other than your spouse, such as an elderly parent, it's wise to
do some advance planning if you can. According to Bonnie Hughes,
CFP, of A
& H Financial Planning and Education Inc., your options
for handling the account are a little trickier. In particular, there
are some thorny rules regarding designating beneficiaries for IRAs.
In most cases, says Hughes, IRA beneficiaries should
be actual, named people -- known as designated beneficiaries --
rather than simply "my estate" or "my living trust."
Another no-no: leaving blank the space on the IRA beneficiary form
(available from the financial institution that holds the account)
in the mistaken assumption that the account automatically will be
distributed to heirs as part of their will.
Why? "Trusts, estates and other entities don't
have life expectancies," says Hughes. If they 'receive' an
inherited IRA, they must draw down,and pay taxes on, the entire
IRA account within five years or according to distribution plan
of the original owner, if the owner had already begun taking distributions
before his or her death, says Hughes.
"On the other hand, if you directly inherit the
account as a designated beneficiary, you have more choices on how
to handle withdrawals. You can even stretch out distributions over
your own life expectancy," she says. "That's where we
get the term 'stretch IRA.'" Stretch IRAs are also known as
"legacy," "super" and "multigenerational"
If you are one of several beneficiaries of an inherited
IRA (say you're sharing it with three siblings), separate the account
as soon as possible. Each of you then can choose how to handle your