Inherited IRA

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What is an Inherited IRA?

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An individual retirement account that is left to a beneficiary after the owner’s death. If the owner had already begun receiving required minimum distributions (RMDs) at the time of his or her death, the beneficiary must continue to receive the distributions as already calculated or submit a new schedule based on his or her life expectancy.

If the owner had not yet chosen an RMD schedule or reached 70.5 years in age, the beneficiary of the IRA has a five-year window to withdraw the funds, which will be subject to income taxes.

A spouse who receives an inherited IRA can choose to roll it over into his or her existing IRA accounts with no penalties. This option does not exist for non-spouse beneficiaries.

Tax laws surrounding inherited IRAs are quite complicated. Beneficiaries should seek the advice of a tax professional if they inherit an IRA.

Because IRAs are relatively new, look for more changes in tax laws over time as the number of inherited IRAs grows.

What to Do With an Inherited IRA

Inheriting an IRA may seem like a good thing, but there can be tax consequences if you aren’t careful. If you inherit an IRA, you should check with an attorney or financial advisor as soon as possible to find out your options.

IRAs are personal savings plans that allow you to set aside money for retirement and get a tax deduction for doing so. Earnings in a traditional IRA generally are not taxed until distributed to you. At age 70 1/2 you have to start taking distributions from a traditional IRA. Earnings in a Roth IRA are not taxed, nor do you have to start taking distributions at any point, but contributions to a Roth IRA are not tax deductible. Any amount remaining in an IRA upon death can be paid to a beneficiary or beneficiaries.

Spouse as beneficiary

If you inherit your spouse’s IRA, you can treat the IRA as your own. You can either put the IRA in your name or roll it over into a new IRA. The Internal Revenue Service will treat the IRA as if you have always owned it. If you are not yet 70 ½ years old, you can wait until you reach that age to begin taking minimum withdrawals. If you are over 70 ½ and were 10 or more years younger than your spouse, you can use a longer joint-life expectancy table to calculate withdrawals, which means lower minimum withdrawal amounts. If you inherit a Roth IRA, you do not need to take any distributions.

You can leave the account in your spouse’s name, but in that case you will need to begin taking withdrawals when your spouse would have turned 70 ½ or, if your spouse was already 70 ½, then a year after his or her death. If you want to drain the account, you can use the “five-year rule.” This allows you to do whatever you want with the account, but you must completely empty the account (and pay the taxes) by the end of the fifth year after your spouse’s death.

Non-spouse as beneficiary

The rules for a child or grandchild (or other non-spouse) who inherits an IRA are somewhat different than those for a spouse. You can choose to take distributions over your lifetime and to pass what is left onto future generations (called the “stretch” option). The required minimum distributions will be calculated based on your life expectancy. This allows the money to grow tax-deferred over the course of your life and to be passed on to your beneficiaries, if you wish. If you want to do this, you must retitle the IRA into an inherited IRA and take your first distribution by December 31 of the calendar year following the year the decedent died.

If you choose not to stretch the IRA, you will have to withdraw it all within five years of the original IRA owner’s death. This can lead to a large tax bill–unless the IRA is a Roth, in which case the distributions are tax-free.

Trust as beneficiary

If the IRA names a trust as the beneficiary, the trust may not be able to take advantage of the opportunity to stretch withdrawals across decades. Stretching an IRA may still be an option, however, if the trust is considered a “see-through” or conduit trust. If you have inherited an IRA in a trust, contact your attorney to find out your options. We can recommend several.

Estate tax deduction

If the decedent’s estate was subject to an estate tax, the IRA beneficiary may be able to get an income tax deduction for the estate taxes paid on the IRA.

Tax issues

Generally, distributions of pre-tax contributions and earnings from inherited IRAs are tax reportable distributions included in your ordinary income. However, distributions of earnings from a Roth IRA may generally be tax-free if the original account owner had held the account for at least five years. When you withdraw from an inherited Roth IRA and the five-year condition is met, your withdrawals will be tax- and penalty-free.

For tax reporting purposes, distributions occur under your Social Security number or the taxpayer identification number of the beneficiary. For any year in which you fail to satisfy the RMD, you must pay an IRS penalty equal to 50% of the RMD amount that was not withdrawn. (The distribution amount is also considered tax reportable and included in your ordinary income.) For information and assistance regarding tax issues, consult a qualified tax advisor.

Deadlines

Here are key dates you should keep in mind to make sure you meet the IRS deadlines that apply to the options you choose.

  • December 31 of the original account owner’s year of death. If the account owner died on or after his or her required beginning date, the RMD for the year must be satisfied if it was not taken in full during the account owner’s lifetime.
  • December 31 of the year following the original account owner’s year of death. If you are taking RMD based on the life-expectancy method, distributions must begin by this date. If you are one of multiple beneficiaries, all beneficiaries must have established separate inherited IRA accounts by this date in order to calculate distributions based upon each beneficiary’s own life expectancy.
  • September 30 of the year following the original account owner’s year of death. Important for determining the beneficiary whose life expectancy may be used to calculate RMD (the designated beneficiary). If you’re one of multiple beneficiaries of varying ages, all beneficiaries must use the life expectancy factor of the oldest beneficiary who has not taken a lump-sum distribution or disclaimed his or her entire interest prior to this date. However, if all of the beneficiaries have established separate IRA accounts by December 31 of the year following the account owner’s death, then all beneficiaries may be able to use their own life expectancy factors to calculate their RMD. Check with your tax advisor to see if you are eligible for this benefit.
  • October 31 of the year following the account owner’s year of death. Important if you are the trustee of a trust named as IRA beneficiary. The IRS mandates that trustees provide Vanguard with a copy of the trust document or a summary list of the trust’s beneficiaries and conditions by this date. If this requirement is not met, or if the trust failed to meet certain other IRS requirements, it’s not considered a qualifying trust eligible for more favorable RMD calculations, usually based on the life-expectancy of the oldest trust beneficiary.
  • Within nine months after the original account owner’s death. If you’re planning to disclaim the assets, your written disclaimer generally must be received no later than nine months after the date on which you become entitled to the assets, according to IRS regulations.

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