Inherited IRA - Not As Easy As It Seems

Receiving an inheritance can be a nice windfall. But, when it comes to inheriting an IRA, the tax rules can be tricky and your decisions regarding this asset can have far-reaching tax implications. Mistakes can be very costly. So, before you decide what to do with it, find out what your options are so you can maximize the dollars you keep.

One of the greatest benefits of inheriting an IRA is the ability to stretch out the account over long periods of time. Stretching defers the income taxes due on the account, allowing your IRA to grow in a tax favorable environment. If you don't need the current income to survive, this is usually your best option. However, everyone's financial situation is unique.

There are important factors that will determine a beneficiary's choices when inheriting an IRA:

1) Who did you inherit the IRA from?
2) What is the timeframe regarding your transfer options?

Inheriting an IRA from a spouse gives you flexibility not available to other beneficiaries. You can put the IRA in your name or you can roll over the funds into an IRA you have already set up.

The IRS will treat this as if the inherited IRA assets were yours all along.

Assuming that you are younger than 70 ½, as a spouse not only are you not required to take any distributions from the inherited money, but it also means that you can make additional contributions to the IRA (assuming you qualify). Converting the IRA into your name will also allow you determine your own beneficiary.

Your other choice is to leave the IRA in your deceased spouse's name. If you are older that your deceased spouse and your objective is to defer the account as long as possible, this a good option because the RMD's will be based on the younger spouse's age. However, if you are younger than your deceased spouse and do not currently need the IRA income, then this option may be less tax efficient that converting the IRA as your own.

This option forces you to take the RMD (required minimum distribition) as required, with the first minimum withdrawal taken no later than:

• December 31st of the year your spouse would have turned 70 1/2 had he or she continued to live, or
• December 31st of the year following the year your spouse dies (if your spouse was already 70 ½). So if your spouse died in 2003 this year, the earliest possible date for a required minimum withdrawal is Dec. 31st of 2004.

Heirs may base the distribution amount either on their life expectancy or that of the deceased owner.

For surviving spouses who are younger than 59 ½ and depend on the income from the IRA for survival, leaving the IRA in your spouse's name is the best option. It allows you to take distributions without incurring a 10% early withdrawal penalty. But, because the IRA remains in your deceased spouse's name, the future beneficiaries cannot be changed.

As a spousal heir, one of the flexibilities of an inherited IRA is that you can split the account. So, let's say you needed some current income from the account (which you will be forced to take for the rest of your life), but don't want to exhaust the whole account, you can split the inherited account into one that generates income (stays in deceased spouse's name) and the other (converted to your own IRA account) to grow, deferring distributions until your RMD age.

Non spouse heirs do not have the option of treating inherited IRAs as your own. This doesn't mean that the money isn't yours; it simply means that you can't make any contributions to that IRA or roll it over to another IRA. Nevertheless, you have choices.

If the decedent was age 70 ½ or greater (and taking distributions out of the IRA when he/she died), then you may start taking money out using the same distribution method. This option is typically not recommended, unless you desperately need the money. If the decedent was not yet taking distributions out of the IRA, you have two IRA distribution options:

1. All of the interest from the IRA must be distributed to you by December 31st of the fifth year after the year the decedent died, (not the best choice) OR
2. All of the interest must be distributed over your life expectancy

This situation is further complicated when a decedent leaves the IRA to multiple beneficiaries.

Let's assume that a father leaves his IRA to his three adult children. Those children must first establish three new "inherited IRA" accounts.

The transfer from the decedent's IRA must be made directly from the old IRA into the three new IRA's by way of a "trustee to trustee transfer". Releasing the funds directly to the beneficiary will prohibit the future rollover of those assets into the inherited IRA, which forces full taxation on the amount distributed (but does not garner a 10% early withdrawal penalty since it was inherited).

In previous years, RMD's were based on the life expectancy of the oldest child, cheating younger heirs out deferral time. However, if the new inherited IRA accounts are established in the year after the year of the owner's death (so if died 2003, then Dec.31 of 2004), then each child will be able to use his/her own life expectancy going forward on their RMD's.

In all of the above scenarios, income taxes are not due until distributions are actually taken.

However, a 50% tax penalty can be assessed for failing to take the required minimum distribution in a timely fashion. So be mindful of your deadlines, because Uncle Sam will be.

Nobody said inheriting money was easy. The rules are quite complex and ignorance can translate into costly mistakes. Do your homework before your act. Remember, as with any other delicate financial matter, you should probably consult your advisor and/or tax professional first.

Additional resources:

Charles Schwab IRA Brochure

IRS Publication 590

Rollover by Non-Spouse Beneficiary

IRS Publication 575 - Pension and Annuity