“One wrong decision can lead to expensive consequences, and good luck trying to persuade the IRS to give you a do-over.”
Inheriting an IRA comes with several constraints. As a result, it can be tricky to navigate. You are at an intersection of tax planning, financial planning and estate planning, says Bankrate’s article “7 inherited IRA rules all beneficiaries must know.” There are a number of choices for you to make, depending upon your situation. How can you figure out what to do?
Whatever your situation, do NOT cash out the IRA, or roll it into a non-IRA account. Doing this could make the entire IRA taxable as regular income. Do nothing until you have the right advisors in place. For most people, the best step is to find an estate planning attorney who is experienced with inherited IRAs.
Here’s what you need to know:
The rules are different for spouses. A spouse heir of an IRA can do one of three things:
- Name himself as the owner and treat the IRA as if it was theirs;
- Treat the IRA as if it was his, by rolling it into another IRA or a qualified employer plan, including 403(b) plans;
- Treat himself as the beneficiary of the plan.
Each of these actions may create additional choices for the spousal heir. For example, if a spouse inherits the IRA and treats it as his own, he may have to start taking required minimum distributions, depending on his age.
“Stretch” or choose the 5-year rule. Non-spouse heirs have two options:
- Take distributions over their life expectancy, known as the “stretch” option, which leaves the funds in the IRA for as long as possible, or
- Liquidate the entire account within five years of the original owner’s death. That comes with a hefty tax burden.
Congress is considering legislation that may eliminate the stretch option, but the proposed law has not been passed as of this writing. The stretch option is the golden ticket for heirs, letting the IRA grow for years without being liquidated and having to pay taxes. If the IRA is a Roth IRA, taxes were paid before the money went into the account.
Non-spouse beneficiaries need to act promptly, if they want to take the stretch option. There is a cutoff date for taking the first withdrawal, depending upon whether the original account owner was over or under 70 ½ years old.
There are year-of-death distribution requirements. If the original owner has taken his or her RMD in the year that they died, the beneficiary needs to make sure the minimum distribution has been taken.
There might be a tax break. For estates subject to the federal estate tax, inheritors of an IRA may get an income-tax deduction for the estate taxes paid on the account. The taxable income earned (but not received by the deceased individual) is “income in respect of a decedent.”
Make sure the beneficiary forms are properly filled out. This is for the IRA owners. If a form is incomplete, doesn’t name a beneficiary or is not on record with the custodian, the beneficiary may be stuck with no option but the five-year distribution of the IRA.
A poorly drafted trust can sink the IRA. If a trust is listed as a primary beneficiary of an IRA, it must be done correctly. If not, some custodians won’t be able to determine who the qualified beneficiaries are, in which case the IRS’s accelerated distribution rules for IRAs will be required. Work with an estate planning attorney who is experienced with the rules for leaving IRAs to trusts.
Reference: Bankrate (Nov. 19, 2019) “7 inherited IRA rules all beneficiaries must know.”