There are several things you should know if you inherit an IRA. Not knowing the proper way to handle these funds can be costly and defeat the purpose of your benefactor in wanting leave you their hard-earned savings. The rules differ for spouses and non-spouses (such as children), but understanding them can be helpful and save you a bit of money.
Any time anyone inherits an IRA, the beneficiary has the ability to cash the account out immediately. While the beneficiary doesn’t have to pay a 10 percent penalty for doing so, s/he will be taxed at the current rate and could face the possibility of being bumped into a higher income tax bracket in the year the lump sum is taken.
There are other options available for spousal non-spousal beneficiaries, which are definitely worth exploring.
Spouses Who Inherit a Traditional IRA
If your spouse names you as beneficiary of their IRA, you have the following options:
- You can transfer the funds/assets into your own (existing or new) IRA. Here you can treat the funds as your own and begin taking distributions once you reach the age of 59 ½. If you make a withdrawal before that age, you’ll incur a 10 percent penalty. Depending on your age, this option gives those funds additional time to grow until you’re required to make withdrawals at retirement age.
- You can also open an inherited IRA, which allows you to take distributions spread out over your own life expectancy. You are required to take the appropriate distribution every year, but you are not liable for the typical 10 percent early withdrawal under this option.
- You also have a choice of taking distributions from the IRA over a five-year timeframe. This allows you some time to liquidate the account without incurring a 10 percent early withdrawal penalty. You’ll be taxed on each distribution, but maintain the ability to earn income on the assets left in the account for the five-year period.
Non-Spouses Who Inherit a Traditional IRA
- You can transfer the funds/assets into an inherited IRA, which requires you to take distributions over your own life expectancy. You must take the first of these distributions by December 31st of the year after the benefactor passed away. Your distributions are calculated based on your age at the time of your benefactor’s death and your own life expectancy. The remaining funds in the inherited IRA continue to earn income, making this a decent choice depending on your situation.
- You can choose the five-year option here, too, allowing you to leave the funds in the IRA for five years after your benefactor’s death. You must liquidate the IRA within that five-year timeframe, and you can do this in yearly increments or in one lump sum before the deadline. Here, funds do have the chance to grow within that five years and you aren’t charged any early withdrawal penalty.
Note: The above rules are a bit different for both spouses and non-spouses who inherit a Roth IRA. Your CPA or financial planner can go over these options with you to ensure the transition complies with IRS regulations.
Understand Year-of-Death RMDs
This applies to all inherited traditional IRAs. If your benefactor is 70 ½ or older when he or she dies, you may be responsible for making the required minimum distribution from their account if it wasn’t taken before their death. The RMD has to be made by the last day of the year in which they passed. Failing to do so could result in a penalty that totals 50 percent of half the amount of the RMD. However, this does not apply to Roth inheritors, or if your benefactor was less than 70 ½ years old. Be sure to consult a financial planner or other expert familiar with how this works to ensure this action is taken correctly.
A Note to Benefactors Who Want to Leave IRAs to Loved Ones
Benefactors who intend to leave their IRAs to spouses and children or even to friends have the best of intentions. However, if you fail to properly fill out the beneficiary form—your intentions may not come to fruition. Yes, your funds will still be left to someone, but an incomplete form could cause your IRA to become subject to your estate. Additionally, the beneficiary could be forced out of being able to use the stretch option and instead required to adhere to the five-year rule.
Review your chosen beneficiaries every year to ensure your last wishes are met. If you do not name any beneficiaries, your IRA becomes subject to the default policy of the retirement account custodian. These rules vary from custodian to custodian. Some custodians award the accounts to the living spouse, others to your estate…but rarely to children.
For additional information, refer to the below publications from the IRS.
If you have questions about this article and want to learn more about alternative investments in your self-directed IRA, call us at (800) 425-0653 or send us a message.