When someone leaves you an individual retirement account, or IRA, you can find yourself at the tricky three-way intersection of estate planning, financial planning and tax planning. One wrong decision with the inherited account can lead to expensive consequences, and good luck trying to persuade the IRS to give you a do-over.
Attorney Natalie Choate advises IRA beneficiaries to do nothing until they’ve met with a financial adviser who can explain their options.
“The worst thing to do would be to cash out the plan, put it in your account, and then go see an adviser and say, ‘Now what?'” says Choate, the author of the retirement-plan guide, “Life and Death Planning for Retirement Benefits.”
At that point, you’re in trouble. Before that happens, learn these eight must-know secrets for handling an inherited IRA.
1 of 9
Choose 5-year rule or stretch IRA
2 of 9
Christopher Futcher/Getty Images
The money in an inherited IRA must be taken out eventually, except in some cases when the beneficiary is the widow or widower of the deceased.
Nonspouse beneficiaries have two options for liquidating the account:
They can choose to take distributions over their life expectancy, known as the “stretch option,” which leaves the funds in the IRA for as long as possible.
They must liquidate the account within five years of the original owner’s death.
The stretch IRA is the tax equivalent of the treasure at the end of the rainbow. Hidden beneath the layers of rules and red tape is the ability to shelter funds from taxation while they grow for decades. In the case of a Roth IRA, earnings accumulate tax-free.
One slip-up by the beneficiary, or even by the benefactor before death, and that tax gem can be lost forever.
Instead, the beneficiary will be forced to take the money out of the IRA under the five-year rule. For substantial accounts, that can add up to a monstrous income tax bill — unless the IRA is a Roth, in which case, taxes were paid before money went into the account.
Distributions from an inherited Roth IRA will be tax-free unless the account was established less than five years before — in which case, the earnings may be subject to tax.
2 of 9
Spouses get the jackpot
3 of 9
Whenever spouses inherit an IRA, they can basically take the account and treat it exactly as if it were their own.
“If your husband passed away, you would inherit that IRA as if you were your husband. If you were not interested in taking money out at this time, you could let that money continue to grow in the IRA until you reach age 70 1/2,” says Frank St. Onge, an enrolled agent in the Detroit area.
If the spouse inherits a Roth IRA, no distributions will be required ever. But there’s an additional wrinkle in that, if the spouse elects to treat the account as his or her own, any distributions taken before age 59 1/2 could be subject to the 10 percent early withdrawal penalty.
Spouses “are able to roll the IRA into an account for themselves. That resets everything. Now they are able to name their own beneficiary that will succeed them and be able to deal with the IRA as if it is their own,” says Carol Tully, a CPA at Wolf & Co. in Boston.
3 of 9
Nonspouse beneficiaries must act soon
4 of 9
Nonspouse beneficiaries shouldn’t procrastinate. In order to choose the stretch option, a beneficiary must take yearly required minimum distributions, or RMDs, based on his or her own life expectancy.
There is a cutoff date for taking the first withdrawal.
“You have to take out your first distribution in the next calendar year by Dec. 31 of the calendar year following the year that the decedent died. If you miss that date, you default back to the five-year rule,” says Tully.
The takeaway for inheritors: Don’t rush to make any decisions, but do be aware that time is running out.
Another hurdle for beneficiaries of traditional IRAs is figuring out if the benefactor had taken his or her RMD in the year of death.
“Let’s say your father dies Jan. 24, leaving you his IRA. He probably hadn’t gotten around to taking out his distribution yet. The beneficiary has to take it out if the original owner didn’t. If you don’t know about that or forget to do it, you’re liable for a penalty of 50 percent” of the required distribution, attorney and author Choate says.
Not surprisingly, that can cause a problem if someone dies late in the year.
“If your father dies on Christmas Day and still hasn’t taken out the distribution, you may not even find out that you own the account until it’s already too late to take out that year’s distribution,” she says.
The last day of the year is the deadline for taking that year’s RMD.
If the deceased was not yet age 70 1/2, or if it’s a Roth IRA, then there is no year-of-death required distribution.
5 of 9
Take the tax break coming to you
6 of 9
For estates subject to the estate tax, inheritors of an IRA will get an income-tax deduction for the estate taxes paid on the account. The taxable income earned (but not received by the deceased) is called “income in respect of a decedent.”
“When you take a distribution from an IRA, it’s taxable income. But because that person’s estate had to pay a federal-estate tax, you get an income-tax deduction for the estate taxes that were paid on the IRA. You might have $1 million of income with a $350,000 deduction to offset against that,” says Choate.
“It’s not necessary that you were the person who paid the taxes; just that someone did,” she says.
For 2017, estates worth more than $5.49 million are subject to the estate tax, up from $5.45 million in 2016.
6 of 9
Don’t ignore beneficiary forms
7 of 9
Alistair Berg/Getty Images
An ambiguous, incomplete or missing designated beneficiary form can sink an estate plan.
Many people assume they filled out the form correctly at one point. “You ask who their beneficiary is, and they think they know. But the form hasn’t been completed, or it’s not on record with the custodian. That creates a lot of problems,” says Tully.
If there is no designated beneficiary form and the account goes to the estate, the beneficiary will be stuck with the five-year rule.
The simplicity of the form can be misleading. Just a few pieces of information can direct large sums of money.
“One form like that can control millions of dollars, whereas a trust could be 50 pages. People procrastinate, they don’t update forms and cause all kinds of legal entanglement,” says M.D. Anderson, founder of InheritedIRAHell.com and president of Arizona-based Financial Strategies, who specializes in inherited IRA issues.
7 of 9
Improperly drafted trusts can be bad news
8 of 9
It is possible to list a trust as a primary beneficiary of an IRA. It is also possible that this will go horribly wrong. Done incorrectly, a trust can unwittingly limit the options of beneficiaries.
Tully says that if the provisions of the trust are not carefully drafted, some custodians won’t be able to see through the trust to determine the qualified beneficiaries, in which case the accelerated distribution rules would come into play.
The trust needs to be drafted by a lawyer “who’s experienced with the rules for leaving IRAs to trusts,” says Choate.
Without highly specialized advice, the snarls can be difficult to untangle.
Some custodians are more versed than others in the complex rules surrounding inherited IRAs.
“Talk about it with the custodian ahead of time. Plans are great, but only as far as the ability to have them properly implemented,” says Tully.
The problem is that a mistake, or bad advice, made on the part of the custodian leaves difficulties for beneficiaries.
Without being an expert yourself, there’s no way of knowing if the institution is simply not up to the task or if your IRA issues are not allowed by the IRS.
“The malpractice is irreversible. You cannot argue abatement of penalty and interest and taxation in an inherited IRA case. There is no justice other than a private letter ruling,” says Anderson. A private letter ruling involves handing over an IRS fee of about $6,000 to $10,000 and then waiting six months for an answer, he adds.
If you’re getting conflicting advice or something seems wrong, don’t sign anything that could lead to something irreversible. Get a second opinion from someone with expertise specific to the inherited IRA area. It really can be that complicated.