Be careful with inherited IRAs

Leaving someone an IRA as an inheritance can have a lot of tax advantages, and it’s often a very good estate planning strategy. However, the rules for inherited IRAs are complicated, and it’s easy to make mistakes.

If you have recently inherited an IRA, or if you expect to inherit an IRA, it’s important to speak to an estate planner or other advisor right away before you make any decisions about the account. And if you’re planning to leave someone an IRA, you’ll want to make sure that person knows what to do, so the tax benefits aren’t lost through an innocent mistake.

The big advantage of an inherited IRA is that the assets may be able to remain in a tax-sheltered account and grow tax-free for years before they’re taken out. So generally, you want to make sure the assets are left in the account for as long as possible.

The exact rules depend on the kind of IRA and whether the beneficiary is the surviving spouse of the owner. For example:

If a surviving spouse inherits a traditional IRA, there are a number of options, but the three primary ones are:

(1) The spouse can roll the IRA into his or her own IRA. This is simple – there’s only one account to deal with – and the spouse can postpone required minimum distributions (RMDs) until age 70½ and calculate them based on his or her own life expectancy. The downside is that there’s a 10% penalty on withdrawals before age 59½, and there might be accelerated RMDs if the surviving spouse was older than the deceased spouse.

(2) The spouse can transfer the assets into a separate account that’s titled as an “inherited IRA.” This is more complicated, but it might avoid the 10% penalty on early withdrawals and the accelerated RMDs. Because of the RMD rules, this option might be better in cases where the spouse who passed away hadn’t yet reached 70½.

(3) The spouse can take the additional step of converting the account to a Roth IRA. This can be smart in certain situations, such as if the spouse expects to be in a higher tax bracket later in life.

If someone other than a spouse inherits a traditional IRA, the beneficiary can transfer the assets into a separate “inherited IRA.” The beneficiary will have to take RMDs starting the next year, but they’ll be based on the beneficiary’s life expectancy, not the owner’s, which can save taxes.

If a surviving spouse inherits a Roth IRA, there are two main options:

(1) The spouse can roll the IRA into his or her own existing or new Roth IRA. There are no RMDs, and distributions are tax-free as long as the beneficiary is at least 59½ and five years have passed since the original owner set up the account.

(2) The spouse can transfer the Roth IRA assets into a separate “inherited IRA.” With this method, the spouse will have to take RMDs, but there can be some tax advantages for early withdrawals.

If someone other than a spouse inherits a Roth IRA, the beneficiary can transfer the assets into a separate “inherited IRA.” The beneficiary will have to take RMDs starting the next year.

In addition, in all of the scenarios above, there are two other options:

  • A beneficiary can always take an immediate lump-sum distribution. But unless this is absolutely necessary to pay bills, it’s by far the worst choice tax-wise.
  • A beneficiary can also disclaim the IRA assets. The advantage here is that the assets might pass to younger family members who can stretch the distributions out over many more years, thus compounding the tax benefits. Also, when the beneficiary dies, the assets won’t be subject to estate tax.

Of course, a disclaimer makes sense only if the beneficiary doesn’t need the assets to live on. Moreover, the beneficiary can’t simply choose who will get the account; it will go to the person who would legally be entitled to it if the primary beneficiary hadn’t been named as a beneficiary.

This is an important point if you’re leaving someone an IRA. You’ll want to carefully consider who should be named as the alternate beneficiary – so that if the primary beneficiary chooses to disclaim, the assets will go to the right person tax-wise.

It’s also possible to leave an IRA to a trust. This can have a number of benefits, such as protecting assets from creditors and preventing a beneficiary from withdrawing the money prematurely and losing the tax benefits. However, it’s very complicated and should only be done with expert advice.

One thing to keep in mind is that a beneficiary may need to act quickly. For instance, there are strict time limits for rolling over inherited IRA assets into a new account.

Also, if an IRA owner passed away before taking out an RMD for the year in which he or she died, the beneficiary must take out the RMD before the end of the year or face a 50% penalty. (In fact, if someone dies late in the year without taking out an RMD, it’s possible that the beneficiary won’t even find out about the bequest until it’s too late to avoid the penalty.)

Finally, if your estate plan involves leaving someone an IRA, it’s critical to make sure your beneficiary designation form is filled out correctly and on file with the IRA custodian. If there’s a glitch and the account ends up going through your estate rather than directly to the beneficiary, the beneficiary might have to completely empty the account within five years, thus destroying most of the tax benefits.

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