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 accounts."
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" IRAs.
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 own account.