Understanding the Options Seven Steps to Take When You Inherit an IRA

More and more people are inheriting IRAs and other retirement accounts as the first big wave of IRA account holders move through retirement. If you find yourself in this position, understanding the available options for inheriting an IRA can help you avoid immediate taxation of this inheritance.

The Individual Retirement Account (IRA) was first established by Congress in 1974, and its growth was fueled by tax-law changes in the early 1980s that increased contribution limits. IRA accounts allow contributors to defer income taxes into the future. At the end of 2010, more than 40{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} of individuals had IRA accounts with more than $4.7 trillion in assets, according to the Investment Company Institute. Direct-contribution retirement plans, such as 401(k)s and 403(b)s, include another $4.5 trillion that may be rolled over to IRAs at some point in the future. Indeed, retirement accounts are a growing percentage of household assets for people entering retirement.

The tax-deferred status of an IRA allows the original account holder to not pay income taxes on their contributions or earnings until the money is withdrawn. Money remaining in an IRA account at the owner’s death will still incur income taxes when withdrawn, but there are options available to continue deferring taxes into the future. If you inherit an IRA, it is important to carefully weigh your options to make sure you can continue to delay paying income taxes as long as possible.

Money can be withdrawn from inherited Roth IRAs tax-free. However, if money is taken out upon inheriting a Roth IRA, you will not benefit from its ability to grow tax-free into the future.

For many people, the best option is to open an inherited IRA or an inherited Roth IRA account and choose to take minimum required withdrawals over their lifetime. This will leave the money in a tax-deferred status, with only small amounts being required to be taken out each year. If you inherit an IRA or Roth IRA and want to withdraw additional money in the future, you can do so without penalty. However, income taxes must be paid on withdrawals from inherited IRAs.

Let’s look at the seven steps you should take if you are in a position to inherit an IRA.

1. Wait and Assess Options

If you inherit an IRA, do not make any decisions until you are sure what rules apply and what all of your options are. The rules dealing with inherited IRAs are different than regular IRAs, and decisions are generally final. For example, with an inherited IRA, all money must move from one IRA custodian to another, which is often referred to as a trustee-to-trustee transfer. A custodian is a financial institution such as Fidelity, Schwab, ING, or Prudential, to name a few. With your own IRA, you can take money out and redeposit it in 60 days without penalty. That is not the case with an inherited IRA. Once you take the money out of an inherited IRA, you will owe taxes, and the taxes cannot be redeposited.

2. Review Beneficiary Forms

The beneficiary form on file with the IRA or retirement plan custodian controls who inherits the account rather than a will. That is why it is very important to fill out beneficiary forms and check them on a regular basis. For maximum flexibility, it is best to have both primary and contingent beneficiaries. Your primary beneficiary then has the option of ‘disclaiming’ the account, allowing it to pass to a younger contingent beneficiary.

If an estate is named as the beneficiary, options to extend tax deferral will be limited. If there is no beneficiary form on file, the default policy of the custodian will apply. In some cases it will go first to a spouse and then an estate; in other cases it will go straight to the estate.

3. Is the Beneficiary a Spouse?

If the beneficiary is a spouse, they have the option to roll the inherited IRA assets into their own IRA and postpone mandatory distributions until they reach age 70½. But if a spouse is younger than 59½, they will have to pay a 10{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} penalty for any early withdrawals.

Spouses and non-spousal beneficiaries possess the following four options: receive a lump sum distribution and pay income tax now (unless it’s a Roth account); transfer the assets to an Inherited IRA (and take distribution over five years); transfer to an inherited IRA (and take distributions over their life); or disclaim (and allow the account to pass to contingent beneficiaries listed on the beneficiary form).

4. Have Mandatory Distributions Been Taken?

If the late IRA owner was 70½ or older, beneficiaries need to determine if the owner’s minimum required distribution for the year has been withdrawn. Minimum required distributions that have not yet been taken must be distributed to the inherited IRA owner(s) before the account can be transferred to their name.

5. Is There More Than One Beneficiary?

If you inherit an IRA along with other heirs, such as siblings, you can split up the account, allowing each heir to spread withdrawals across his or her own life expectancy. Otherwise, the life expectancy of the oldest heir is used for everyone to determine required minimum distributions. Splitting the account also allows each beneficiary to choose their own investment strategy.

6. Open an Inherited IRA

Once you have walked through the first five steps, you are now ready to open an inherited IRA or inherited Roth IRA account. Inherited IRAs cannot be rolled into your own IRA account, and IRAs that you inherit from different people must be kept in separate accounts. You will be required to open an inherited IRA account as the custodian who holds the IRA, 401(k), or 403(b).

Each institution will have its own naming rules, but it is important that both your name and the deceased are included in the account title. A sample title is “John Smith IRA / Deceased 1/1/2009 / FBO [for the benefit of] Mary Smith.” Once the account has your name in the title, you can transfer the inherited IRA to the custodian of your choice — usually where you have other personal accounts. Most financial institutions will allow you to open an inherited IRA, including brokerage firms, insurance companies, and banks. You will also need to choose how to invest the account.

7. Begin Taking Withdrawals

After you open your inherited IRA or an inherited Roth IRA account, you will need to take minimum required distributions every year for the rest of your life or until the account is closed. The first withdrawal must be taken by Dec. 31 of the year following the year of the original owner’s death. Minimum required distributions are calculated based on the IRS’ single life-expectancy table for your age.

The rules for inherited IRA accounts are different from regular IRA accounts, which can be confusing to people who are dealing with an inherited IRA for the first time. Each inheritance comes at a time of personal loss, adding to the difficulty in responding to new circumstances with different rules. Avoiding quick decisions and making sure you understand the inherited IRA rules will assist you in making your inheritance most beneficial to you.

Doug Wheat, CFP, is director of Family Wealth Management in Holyoke;www.fwmgt.com