Category: Financial Planning
Inheriting an IRA can be a blessing. Dealing with the IRS distribution rules can be a headache. Understanding your options will allow you to avoid unnecessary penalties.
If you are the beneficiary of an Individual Retirement Account (IRA) and the IRA owner passes away, what are your options? In order to avoid immediate payment of income tax, you need to understand the rules and meet the time schedule required by the IRS.
Non-spouse as the Beneficiary
If you inherit the IRA of your parent, other relative, or friend, the account becomes designated as an Inherited IRA. The title of the account generally includes the names of the deceased owner and the beneficiary, such as "John Doe Inherited IRA for the benefit of Jane Smith."
If you are the beneficiary of IRA, you cannot combine the Inherited IRA with any other IRAs that you own. Likewise, you cannot make contributions to the Inherited IRA.
You, as the beneficiary, are required to distribute funds from the Inherited IRA based on one of three options. Even though you may be younger than age 59 1/2 years, there is no penalty for "early distributions" as would be the case for an owner of an IRA. Any funds received from the Inherited IRA, less the allowance for after-tax contributions by the owner, are subject to income tax. Therefore, your choice for the distribution method should be considered with your own personal tax planning and cash flow needs in mind. Some of the methods require you to carefully calculate the distribution amount and to meet a particular time schedule to avoid penalties and taxes.
1. Lump-sum Now. You can take 100 percent of the funds immediately. The taxable amount is included on your tax return for that year.
2. Distribute Any Amount over Five Years. You can receive any amount you would like during the period ending on December 31 of the year containing the fifth anniversary of the death of the account owner. For example, if the owner of the IRA died on June 1, 2012, all the funds must be distributed to the beneficiary prior to December 31, 2017. Using this method, you can spread the distributions over as many as six tax years or you can decide to withdrawal the entire amount in the last year of the period.
3. Distribute over Lifetime. You can spread the distributions over your life expectancy. This allows the funds in the account to continue to accumulate on a tax-deferred basis for the maximum time period. To take advantage of this method, you must do the following:
-Take your first distribution by December 31 of the year following the year of the account owner’s death. Per our example above, if the owner died on June 1, 2012, the first distribution must be received by December 31, 2013.
-Calculated the amount of the distribution based on the factor provided in the "single life expectancy table" provided by the IRS. If we assume that the beneficiary is age 46, the table provides a life expectancy factor of 37.9. The value of the IRA on December 31 of the previous year is divided by 37.9 to determine the minimum distribution amount. For each of the following years, the factor is reduced by one. Therefore, in the second year, the factor would be 36.9; the third year it would be 35.9, and so on.
-Withdraw at least the minimum amount that is calculated for each year. You can always withdraw more than the minimum. However, on any required amount that is not withdrawn, you will be subject to a 50 percent penalty.
Spouse as the Beneficiary
If you inherit the IRA of your spouse, you can treat the IRA as if it were your own. Treating the IRA as your own allows you to continue the tax deferral of the existing funds and to withdraw minimum distributions based on your age. If you qualify, you can make annual contributions to the IRA or convert the IRA to a Roth IRA. You can handle the account in two ways:
-You can maintain the account as is and simply change the designated owner to yourself. The rules for distribution are then based on your age and not the age of your deceased spouse. This means that you cannot withdraw money from the IRA until your age of 59 1/2 years without paying the 10 percent penalty. Likewise, at your age of 70 1/2 years you are required to withdraw the minimum distribution amount.
-Instead of maintaining the existing account, your second choice is to roll the funds of the deceased spouse’s IRA into your own IRA account. Combining the funds will reduce the number of accounts and simplify your recording keeping.
In addition, if you inherit the IRA from your spouse, you can elect to be treated as a "non-spouse" beneficiary and utilize any of the methods described above. Handling the IRA in this manner will allow a spouse under the age of 59 1/2 years to receive the funds from the Inherited IRA without paying the 10 percent penalty.
Inheriting a Roth IRA
If you inherit a Roth IRA, the same rollover and distribution rules discussed above apply for both a spouse and non-spouse beneficiary. However, the distributions are not subject to income tax. For this reason, a Roth IRA is a very attractive asset to pass to children. If the child takes the option to distribute the Inherited Roth IRA over his/her lifetime, the account will continue to grow income tax-free.
Inheriting a traditional or Roth IRA can be a financial benefit to you and your family. As the beneficiary of a traditional IRA, you have the opportunity to spread the impact of taxation over several years or even your lifetime. If you inherit a Roth IRA, with proper planning, you can preserve the tax-free generating character of the account for you and your beneficiaries.
Elaine E. Bedel, CFP, is president of Bedel Financial Consulting, Inc., a wealth management firm providing fee-only financial planning and investment management services for individuals, consulting services for corporate retirement plans, and investment advisory for institutions and endowments. She is the author of "Advice You Never Asked For…But wished you had!" available on Amazon.com. For more information, visit their website at www.BedelFinancial.com or email to firstname.lastname@example.org.
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