Inherited
IRA Rules: What You Need To Know
Many people who inherit IRAs are
unfamiliar with the rules that apply to them. My article for Forbes magazine, “Five Rules
For Inherited IRAs,” gives a broad overview of the subject. In this post I answer
questions from two readers with concerns that affect other people, too.
Michael Twersky, a 26-year-old
consultant in New York, asks:
I inherited a $15,000 traditional
IRA from my father. As a child beneficiary, will I avoid income tax
upon withdrawal if I wait until I’m 60? If not, would it be better
to withdraw now while I’m still in a pretty low tax bracket?
You don’t have the option of waiting
until you are 60 to take withdrawals. Generally, non-spousal IRA heirs must
withdraw a minimum amount each year, starting by Dec. 31 of the year after the
IRA owner died. Note: This is true whether it’s a traditional IRA or a
Roth (a common misconception).
To calculate this distribution, you
take the balance on Dec. 31 of the previous year and divide it by the
inheritor’s life expectancy, as listed in the IRS’ “Single Life Expectancy”
table. (You can find the table in IRS Publication 590, “Individual RetirementArrangements
(IRAs),” which downloads here as a
PDF.) Unless the account is a Roth, there is income tax on this required
payout.
Don’t make the mistake, as some people
do, of using the number from the table to figure a percentage. In subsequent
years, you simply take the number you used in the first year and reduce it by
one before doing the division.
If they choose to, IRA inheritors
can draw out these minimum required distributions over their own expected life
spans, as explained here. This is
known as the stretch-out – a financial strategy to extend the tax advantages of
an IRA. Stretching out the IRA gives the funds extra years and potentially
decades of income-tax deferred growth in a traditional IRA or tax-free growth
in a Roth IRA. This is a wonderful investment opportunity.
If you weren’t
aware of the minimum distribution requirement and have not taken the required
withdrawals, see my post, “What
Happens When IRA Inheritors Miss A Key Deadline.”
6/09/2010 @ 6:00PM
Five Rules For Inherited IRAs
Before they inherited $3 million in
retirement accounts from their father last year, the three middle-aged siblings
didn’t know it was possible for heirs to stretch out the tax benefits of such
accounts for decades. But what they also discovered after his death is that
doing this is tricky–and in some cases impossible–if the original owner of the
accounts didn’t fill out his beneficiary forms just so. Although their 78-year-old
dad was a lawyer, “He may never have realized that it made any difference,”
says a daughter, who has spent days trying to sort it all out.
Whether you’re inheriting an IRA or
aiming to protect your own heirs, you’ve got to dance the IRS jig.
1. First, do no harm.
If you inherit a retirement account,
don’t do anything until you know exactly what rules apply. With your own IRA
you can take the money out and redeposit it in another IRA within 60 days
without penalty. Not so an inherited IRA. All movement of money must be from
one IRA custodian to another–be sure to specify a “trustee-to-trustee”
transfer. Moreover, unless you’ve inherited from a spouse, you must retitle the
IRA, including the original owner’s name and indicating it is inherited, e.g.,
“Daddy Warbucks, deceased, inherited IRA for the benefit of Little Orphan
Annie, beneficiary.”
If two or more people are named as
beneficiaries, ask the custodian to split it into separate inherited IRAs. That
avoids investment squabbles and allows a longer stretch-out for the younger
heirs.
2. Beneficiary forms rule.
The beneficiary form on file with
the custodian of an IRA controls both who inherits it and its ability to be
stretched out. If people other than a spouse are named as heirs, they must
begin taking distributions from the account by Dec. 31 of the year after
inheriting, but they can draw these out over their own expected life spans,
enjoying decades of income-tax-deferred growth in a traditional IRA or tax-free
growth in a Roth IRA. To give your heirs maximum flexibility, name both primary
and alternate individual beneficiaries–say, your spouse as primary and kids as
alternates or your kids as primary and grandkids as alternates. Your primary
beneficiary then has the option of “disclaiming” or turning down the account,
enabling it to pass to the younger alternate.
By contrast, if an estate is named
as beneficiary, tax deferral is cut short. If it’s a Roth IRA, all funds must
be withdrawn within five years. For a traditional IRA the same rule applies unless
the former owner was already 70 1/2–the age at which a traditional IRA owner
must begin cashing out. In that case the distribution rate for the heir is
based on the age of the person who died, notes Rockville Centre, N.Y. CPA
Edward Slott.
What if there’s no beneficiary form
on file? Heirs are at the mercy of the IRA custodian’s default policy. Vanguard
Group and Ameriprise award an IRA first to a living spouse and then to the
estate. Merrill Lynch sends it straight to the estate. Few custodians will pass
on an IRA directly to the kids without a beneficiary form.
3. Employer plans are different.
By federal law the money in a 401(k)
goes to a spouse, unless he or she has signed a form waiving rights to it. But
some employer plans will allow the funds to go straight to the kids if no
spouse is living and no beneficiary form is on file. On the other hand,
employers usually won’t let nonspouse beneficiaries stretch out 401(k)
withdrawals. These beneficiaries should ask the employer to transfer the money
into an inherited IRA. They can then divide it into separate inherited iras,
says Natalie B. Choate, a lawyer with Nutter McClennen & Fish in Boston.
4. Spouses have more options.
A spouse who inherits–let’s assume
it’s the wife–has an option not available to other inheritors. She can roll the
assets into her own IRA and postpone distributions from a traditional IRA until
she turns 70 1/2. The catch is, like other IRA owners she may have to pay a 10%
early-withdrawal penalty if she takes money before age 59 1/2 from her own IRA.
So a young widow should generally wait until after reaching 59 1/2 to do the
rollover, says Brooklyn, N.Y. CPA Barry C. Picker. Meanwhile, she doesn’t have
to take out any money until her late spouse would have turned 70 1/2.
5. Watch for distribution traps.
If the late IRA owner was 70 1/2 or
older, beneficiaries must make sure the owner’s mandatory distribution for the
year of death is withdrawn before doing anything else. When nonspouse
beneficiaries take their own payouts, they should be aware of two quirks.
First, if the estate paid estate tax, they may be able to take an itemized
deduction to offset some IRA income. Second, the minimum is calculated
differently than for your own IRA. You take the balance on Dec. 31 of the
previous year and divide it by your life expectancy listed in the IRS’ “single
life expectancy” table, rather than the table used by IRA owners. The next year
you use the same life expectancy, minus a year. (With your own IRA, you take a
new life expectancy from a table each year.)
In the first season of "Friends," Rachel Green looks at her first paycheck as a waitress and asks, "Who's this FICA guy, and why is he getting all my money?"
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