What Happens When You Inherit an IRA?

April 08, 2013

Last week, I received a difficult but important question from a good friend who wanted to know what to do when an IRA account is inherited from a loved one. His mother is in the final stages of a long battle with cancer and the need for hospice care had prompted my friend and his family to start the emotional process of making sure her estate plan is in order. Unfortunately, most families wait until it’s too late to have these difficult talks but in this case, my friend’s question was driven by the difficult ordeal his family experienced following the sudden death of his father about five years ago. They didn’t want to get blindsided this time around but weren’t sure about what tax laws and potential surprises were waiting for them.

When a loved one passes away, there is often an overwhelming list of things to do and inheriting assets may become a stressful experience. Here are some important steps to take if you inherit an IRA or simply want to make sure your loved ones aren’t hit with a tax surprise:

Understand options for spouse v non-spouse beneficiaries. If you’re a surviving spouse, you have the option to either roll the account into your own IRA or continue to own the account as a beneficiary. Either way, you’re not required to start taking distributions until the account owner reaches 70 ½ years of age (or when they would have reached 70 1/2 if it’s still in your deceased spouse’s name). If you’re a non-spouse beneficiary, avoid trying to rollover to an existing IRA since the surviving spouse is the only person with the ability to co-mingle funds with another IRA. Instead, you might want to establish an Inherited IRA account (sometimes called a beneficiary IRA) to avoid tax headaches and provide more control. That’s because in order for non-spouse beneficiaries to avoid a taxable distribution, the original owner’s name needs to be on the account (i.e., “Jane Jones (deceased 12/31/2012) Inherited IRA for the benefit of Susan Jones, Beneficiary”). It’s also important to remember that unlike IRA rollovers, there is no 60-day rollover window and any distributions received directly become taxable even if you place them back into an IRA account.

Regardless of your age, there is no 10% penalty for distributions. Unlike most traditional IRA distributions made prior to age 59 ½, you will not be penalized for taking a distribution no matter your age. With the possible exception of Roth IRA distributions, which are tax-free as long as they meet the 5-year rule, distributions from an Inherited IRA are taxed at the ordinary income rates.

Know when to begin required minimum distributions. The IRS has a set of rules that determine when and how much you must take distributions from retirement accounts. You don’t want to get this one wrong because the tax penalty is equal to 50% of the amount that needed to be withdrawn. In general, non-spouse beneficiaries must begin taking distributions from the inherited IRA the following year after the death of the original owner. For example, if the original IRA account owner dies in 2013, the first required minimum distribution must be taken by December 31, 2014.

IRA beneficiaries should understand stretch IRA rules. As a beneficiary, you can continue tax-deferral as long as possible by stretching out the distributions over the course of your lifetime. You can determine the amount to take out of the Inherited IRA by using the IRS Single Life Expectancy Table. Just don’t forget to subtract a year from the initial life expectancy factor that was used.

When there are multiple beneficiaries, new Inherited IRA accounts should be established. When an IRA is inherited by multiple beneficiaries, the age of the oldest remaining beneficiary is used to determine required minimum distributions. Splitting beneficiary accounts will avoid potential family investment disputes and the younger beneficiaries will be allowed to stretch their required distributions over a longer life expectancy. As our CEO pointed out in a Forbes blog, you can also choose to disclaim an inherited account to pass it directly to secondary beneficiaries to avoid creditors, minimize estate or income taxes, or correct mistakes on beneficiary forms.

You might also be able to take the distributions over 5 years. As long as the original owner passed away before April 1st of the year following the year they would have turned age 70 1/2, you can also choose to distribute the entire account over a 5 year period rather than over your life expectancy. In this situation, you can decide how and when you receive distributions as long as the entire account has been distributed in 5 years.

Inheriting assets can be complicated by the emotions of dealing with the loss of a loved one. With a basic understanding of your options, you can make this decision with confidence if you are ever faced with this challenge. In the meantime, it doesn’t hurt to check your own IRA(s) to make sure your beneficiary information is up to date.