What to Do When You Inherit an IRA/ June 24th, 2013
An inherited IRA (individual retirement account) can be a welcome boost to your own retirement savings...if you make smart decisions from the get-go. Your first impulse might be to cash in the IRA and either spend the money or put it in another account, figuring you'll decide later what to do with it. Either step is usually a huge mistake. You'd severely limit your choices about what you could do with the IRA later, you'd lose its long-term earning power, and you could end up losing a sizable portion of it to taxes, says Dennis Zuehlke, compliance manager at Ascensus Inc., a company based in Middleton, Wis., that partners with financial institutions to offer retirement plan solutions. "As the beneficiary, the onus is on you to do your homework," Zuehlke says. "Find out what the options are and then choose the best one for you." The rules can get complicated, and you may have special circumstances that introduce further complications. If you need help, seek professional advice from someone well-versed in the intricacies of inherited IRAs.
Inheriting from a spouseThe rules are simplest if you inherit an IRA from your spouse. Essentially, you can treat the inherited IRA as though it's yours. You can put it in your name or roll it over into a new IRA in your name. Remember to choose beneficiaries. When you reach age 70½, you must begin taking required minimum withdrawals, which are taxable from a traditional IRA. Roth IRAs have no withdrawal requirements. Younger spouses may want to take a different tack. If you're younger than 59½ and withdraw money from an IRA that's now in your name, you'll usually have to pay the 10% penalty for early withdrawals, with some exceptions. Not a pleasant prospect. But if you need money to cover expenses after your spouse's death, you may have no choice but to withdraw from the IRA.
As a nonspouse, you can't make additional contributions to an inherited IRA. Spouses can treat the inherited IRA as though it's theirs.If you think you'll be in that situation, then don't put your deceased spouse's IRA in your name. Instead, retitle it as an "inherited IRA." "It's extremely important that it be titled correctly," Zuehlke says. "It must clearly identify who the beneficiary is and who the original owner was." For example, it would state: Jim N. Smith IRA (deceased May 10, 2013) for the benefit of Kathy B. Smith, beneficiary. Now that it's set up as an inherited IRA, "you can take an early distribution without paying the 10% penalty, even if you're under age 59½," Zuehlke says, "because it's treated as a death distribution." If you're younger than your deceased spouse, you may want to retitle that IRA again, if it's a traditional IRA, when you reach age 59½. Put it in your name so you can defer required withdrawals until you reach 70½. Otherwise, you would need to start taking required withdrawals when your spouse would have reached age 70½.
Inheriting from a nonspouseYour options are much more limited if you inherit an IRA from someone who was not your spouse. You can't simply put the IRA in your name or roll it over into your own IRA. Say Aunt Sally left you an IRA. You could cash it in, but you'll owe taxes on it if it's a traditional IRA. A Roth IRA withdrawal, however, is tax-free if it satisfies the five-year holding period requirement. That means Aunt Sally must have opened a Roth five full calendar years before her death. This could be any Roth, not just the particular one you inherited. If the five-year holding period has been met, you can withdraw tax-free from the Roth you inherited.
Nonspouse beneficiaries have limited options.But, if you don't need the money and you want the IRA—whether it's a Roth or traditional—to grow into an even bigger nest egg, then keep it as an "inherited IRA," by retitling it according to the wording mentioned earlier. As a nonspouse, you also will have to make required withdrawals each year, whether it's a traditional or Roth IRA, and no matter your age. Those withdrawals must begin by December 31 of the year after the original IRA owner died. "That IRA will pay out to you over your lifetime," Zuehlke says. "Payments will continue over your life expectancy during your working years and into retirement. So it's a great way to supplement your own retirement." Now, let's say Aunt Sally died before she reached her "required beginning date," or RBD—the date by which she would have had to begin taking required withdrawals from a traditional IRA (not required for a Roth). That date is April 1 following the year she turned or would have turned 70½. If Aunt Sally hadn't yet reached her RBD when she died, you have one more option for what to do with the IRA she left you. You could withdraw the assets over a five-year period after her death. If you choose this option, you must withdraw all the money before the five-year period expires. By spreading the withdrawals over five years, you'll lessen the tax burden, if it's a traditional IRA, each year. But, again, you lose money you could have earned if you'd just let that money continue to grow for years, even decades, by keeping it as an inherited IRA.
As a nonspouse beneficiary, you must make required minimum withdrawals each year, no matter your age or IRA type.If you're a nonspouse and you're not sure right away what to do when inheriting an IRA, then go ahead and retitle it now, Zuehlke recommends. "That gives you some flexibility," he explains. "If you decide in a couple years that you need the money, then you can take it out."
More rules...Here are a few more points you should know about inheriting IRAs:
- If the deceased died and had not yet taken his or her required withdrawal for the year, then you, as the heir, must be sure to take that withdrawal before the end of the year. Failure to do so results in penalties equal to 50% of what was supposed to have been withdrawn.
- As a nonspouse, you can't make additional contributions to an inherited IRA. It exists solely to make payments to you, the beneficiary, over time, not for you to put money into it.
- If there are multiple nonspouse beneficiaries, each gets a share of the IRA. Each can choose to keep his or her share as a separate inherited IRA.
- Perhaps you don't need the money and you'd prefer it go to another named beneficiary. You can accomplish this by "disclaiming" the inherited IRA.
- If you're the one who's leaving IRAs to others, consider providing information to your heirs now. They'll need to know what they're dealing with someday down the line. Don't assume just any financial adviser will be able to guide them through this. Not all advisers are knowledgeable about the complex ins and outs of inherited IRAs.
Neither the publisher nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.