You’re likely to inherit an individual retirement account during one of the worst times in your life, when a loved one passes away. But even during this difficult time, it’s important to pay attention to the rules and deadlines so you can best avoid taxes and penalties on the inheritance your family member left behind. Here’s how to make the most of an inherited IRA:
Remember the first required minimum distribution. If the deceased owner of the IRA account has already been taking retirement account distributions, you must continue that distribution schedule until the end of the calendar year. “If dad was taking distributions, you have to make sure that dad takes his final distribution in the year of his death, otherwise there is a 50 percent penalty on the amount he was supposed to take,” says Joseph Harowski, a certified financial planner and president of Smart Choice Financial Planning in St. John, Ind. “Then you go in and recalculate the distribution based on your life expectancy.” Income tax will be due on each traditional IRA withdrawal.
Calculate the new distributions. After the year of the owner's death, you must base required minimum distributions on the longer of your life expectancy or the owner’s life expectancy. You will need to divide the account balance at the end of the year by a government estimate of your life expectancy. If the account owner died before he or she was required to take distributions from the account, your annual distribution (beginning the year after the owner’s death) can be calculated using your life expectancy or distributed at any time over a period of five years. “If you want to continue that tax deferral as long as possible, you need to choose the life expectancy method,” says Carleton McHenry, a certified financial planner for McHenry Capital in Texas.
The distribution method you choose will determine how much tax is due on withdrawals from the account. “The best way of dealing with an IRA is to stretch it out over your lifetime,” says Bernie Strout, a certified financial planner for Gitterman & Associates Wealth Management in Iselin, N.J. “Let’s say you have a $100,000 IRA from someone who was 70 when they passed away, and you only get a 5 percent return. You would get over $200,000 by stretching it out in the IRA, but if you take that $100,000 and you cash it right in, you are going to lose a good portion of it to income tax and then also potentially to state income tax. You could lose 50 percent of it.” If you fail to take a required minimum distribution, you will have to pay a 50 percent excise tax on the amount that should have been withdrawn.
Special rules for surviving spouses. IRAs inherited from a spouse have different rules than those inherited from other relatives or friends. Spouses have the choice to treat an inherited IRA as their own and roll it into their own retirement account or to be a beneficiary and begin taking taxable distributions from the account. Moving the inherited IRA into their own account allows spouses to continue to defer paying income tax on the inherited traditional IRA until they withdraw the money. “You want to keep that tax deferral as long as possible,” McHenry says. “From a tax perspective, it always makes better sense for he or she to roll.”
If the account owner died before the year he or she turned 70½, distributions to the spouse do not need to begin until the year the owner would have reached age 70½. “I have my younger clients leave it as a spousal IRA until they are older, because if they need to touch it as a spousal IRA, there is no early withdrawal penalty,” Strout says. Spouses who receive a distribution from a deceased spouse's IRA have 60 days to put the money into their own IRA before it will be considered a taxable distribution.
Label the account correctly. The money in an inherited IRA can be moved to a new financial institution without incurring taxes or penalties if you make a trustee-to-trustee transfer into another IRA that is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. You will need to take distributions from the new IRA using the same beneficiary distribution rules as under the old IRA.
Consider separating accounts. If an IRA account has multiple beneficiaries, the age of the beneficiary with the shortest life expectancy will be used to calculate required minimum distributions. However, an IRA can also be split into separate accounts for each beneficiary, which could allow younger beneficiaries to reduce their minimum distribution requirement and tax bill. “If it’s you and your siblings, the best thing to do is to split up the account evenly among multiple beneficiaries and have each of the distributions based on your individual life expectancy,” McHenry says. “You have to separate the account out by the end of the year following the year of the death, otherwise distributions will be based on whoever the oldest beneficiary is.”