all about How To : What Is an Inherited IRA? 5 Rules You Should Know

What is an Inherited IRA? 5 Rules You Should Know Kathleen D. says, “My daughter is an American working and going to school in Norway. Her father died in January and left her a traditional IRA. Can she roll it over to an account in her name in the U.S.?”

Thanks for your question, Kathleen, and my condolences for the loss in your family.

As if retirement accounts weren’t confusing enough, there are special rules that apply when you inherit one.

In this post, I’ll answer Kathleen’s question and explain what happens when a friend, family member, or spouse leaves you an IRA. We’ll cover 5 important rules you should know to avoid costly mistakes that could trigger huge tax penalties.

Free Resource: Retirement Account Comparison Chart (PDF download)—handy one-page resource showing the rules for the most popular retirement accounts

What Is an IRA?

An IRA or Individual Retirement Arrangement is a special type of account that shelters contributions and investment growth from some amount of tax. These tax-advantaged accounts make it a whole lot easier to save a bigger nest egg for retirement.

The two main types are traditional and Roth IRAs. Here’s a brief summary of the major differences between them:

Traditional IRAs defer taxes on contributions and earnings, but you have to settle up when taking withdrawals—even from an inherited account. If you take money out before reaching age 59½, you must pay income tax plus a 10% early withdrawal penalty. And you must begin taking withdrawals once you reach age 70½.
Roth IRAs require tax on contributions before they go in the account, but allow you to withdraw contributions and earnings tax free. However, if you make Roth withdrawals before age 59½, amounts that were not previously taxed, such as investment growth, would be subject to income tax plus a 10% early withdrawal penalty. With a Roth, there is no deadline to take withdrawals.

What Is an Inherited IRA?

An inherited IRA, also known as a beneficiary IRA, is a type of IRA that was designed just for retirement plan beneficiaries. You can create either a traditional inherited IRA or a Roth inherited IRA. The custodian of the deceased person’s IRA transfers funds directly into an inherited IRA in your name.

Assuming you want to inherit the IRA you were given (you can disclaim it if not), here are the options when the deceased person was not your spouse:

Cash it out in a lump sum distribution without creating an inherited IRA.
Open an inherited IRA and take minimum distributions over a 5-year period
Open an inherited IRA and take minimum distributions over your remaining life expectancy.

If you were married to the decedent, you have the above three options, plus a fourth: assume ownership by rolling over the funds into your own IRA.

5 Rules You Should Know About an Inherited IRA

If you inherit an IRA from your husband or wife as the sole beneficiary, you have more options than if you inherit one from a friend or family member.

Keep reading to learn more about the right way to handle an inherited IRA and I’ll give a recommendation for Kathleen's daughter. Here are 5 rules for inheriting an IRA that you should know:

Rule #1: Spouses can treat an IRA inheritance as their own

If you inherit an IRA from your husband or wife as the sole beneficiary, I mentioned that you have more options than if you inherit one from a friend or family member. You can assume ownership and treat it just like it’s your own IRA.

In other words, you’re allowed to transfer or rollover your deceased spouse’s IRA into your own IRA without paying any penalties. If you don’t already have an IRA, you can open a new one just for this purpose. Once the inherited funds are in your IRA, the same rules apply as if the funds had always been yours.

Note that you can only rollover funds into the same type of account. For instance, if your spouse left you a Roth IRA, you can only put it in your existing Roth IRA or a new one. If you’re a high-earner and don’t qualify for a Roth IRA, you can own and manage the account, but just can’t make any new contributions to it.

Rule #2: Non-spouses can’t treat an IRA inheritance as their own

When you inherit an IRA from someone other than a spouse, such as a parent or sibling, you can’t treat it as your own. That means you’re not allowed to roll over any amounts into or out of the account or to even make new contributions to it.

When you’re the beneficiary of an IRA from a non-spouse you must open an inherited IRA and have the custodian do a direct transfer into the account on your behalf. You must set up an inherited IRA at the company where the money is, then you can easily move it to another institution later on.

Never rollover inherited funds from a non-spouse into an existing IRA! It’s against the rules for you to take control of the distribution and means you could owe a huge amount of income tax, plus a 10% early withdrawal penalty.

So I want to repeat that you can only rollover IRA funds left to you by a spouse. It’s a small detail that trips up a lot of people who get blindsided by a big, unexpected tax bill.

Remember that you can only rollover IRA funds left to you by a spouse. It’s a small detail that trips up a lot of people who get blindsided by a big, unexpected tax bill.

So getting back to Kathleen’s daughter, she absolutely cannot rollover her father’s account into her own IRA. She must request that the custodian of her father’s account open an inherited IRA and complete a trustee-to-trustee transfer on her behalf. In the next rule I’ll cover more requirements when you have an inherited IRA.

Rule #3: Non-spouses have required minimum distributions (RMDs) for an inherited IRA

When you have an inherited IRA, the government wants to make sure that you’re going to pay the tax bill sooner rather than later. So they impose required minimum distributions or RMDs on both traditional and Roth accounts.

I want to clarify that ordinarily you never have to take required minimum distributions from a Roth IRA. But when you’re the beneficiary of one and have an inherited Roth IRA, you do.

There are two different distribution methods to choose from:

Life expectancy method - is also known as the stretch method because you take distributions in annual amounts spread over many years. You divide the account value by your life expectancy from an IRS table.

For example, a 40-year-old who inherited a $100,000 traditional IRA would be required to distribute and pay tax on about $2,300 ($100,000 / 43.6) per year. Once you set the life expectancy method in motion, you’re required to make the minimum withdrawal based on your age—but you can take out more if you want.

All withdrawals from a traditional inherited IRA are taxed and the remaining account balance continues to grow tax-deferred. Withdrawals from a Roth inherited IRA are never taxed, as long as it’s been open at least 5 years, otherwise only earnings are taxable.

You generally must begin taking distributions by December 31 of the year following the death of the account holder. If you miss this deadline, the five-year method, which we’ll cover next, becomes your default distribution method.

The life expectancy method allows you to leave funds in an IRA and shelter them from taxes for as long as possible, and gives you the most flexibility--so I recommend it for Kathleen’s daughter.

Five-year method – allows you to liquidate the account over 5 years after the death of the account holder. After that period any remaining balance must be fully distributed. You’re taxed on every distribution (unless you have a Roth, as previously mentioned).

With this method, you're not required to take distributions each year, but you must empty the account by December 31st of the fifth year following the account holder's death.

While choosing one of these distribution methods is required when you inherit an IRA from someone who was not your spouse, spouses can opt to have an inherited IRA as well. It can be a good choice if you become a widow or widower at a young age because you could tap the funds early and avoid the hefty 10% early withdrawal penalty.

Rule #4: Cashing out means taking a big tax hit

Let’s say you’re in a financial bind and really need to cash out the full amount of a traditional IRA inheritance. As tempting as it may be to take a lump sum distribution, I don't recommend it. As a beneficiary you wouldn't have to pay a 10% penalty--but you would have to pay a big tax bill all at once (unless you inherit a Roth).

A better plan is to establish an inherited IRA so you have flexibility to take minimum distributions or more each year, and to continue deferring taxes on the portion you leave in the account. You can transfer the account to a different company without any tax penalty and choose to invest the money in any funds you choose.

Rule #5: Maintain your retirement beneficiary forms

Once you open up a retirement account and designate one or more beneficiaries, don’t forget about them. After a form is on file with the custodian of a retirement account, it controls who inherits it.

If you get married, divorced, or have children and don’t update beneficiary forms with your wishes, someone who you really don’t want to inherit your account could get it! There are countless ex-spouses who inherit loads of money every year by mistake simply because someone forgot to remove them from a beneficiary form.

I recommend that you always name primary and secondary beneficiaries to give your heirs as many options as possible. Perhaps you might name a spouse as primary, your children second, and your parents or siblings third.

If you fail to list a beneficiary your heirs will be at the mercy of the custodian’s policy. Some will give it to the deceased person’s estate first. Others may award it to it to a living spouse.

The bottom line is that your loved-ones are counting on you to take care of them financially. So always know who you’ve designated and make updates as needed so you’re in full control of who will get your hard-earned money.

Get Professional Advice About Your Inherited IRA

Inheriting a retirement account can be a wonderful windfall, but it's also easy to make costly mistakes with it. So be sure to get good advice about how to manage it. Contact the account holder's custodian as quickly as possible so you can discuss the best options and meet deadlines that have a huge impact on your financial future.

Kathleen thanks for your question! Even though your daughter is out of the country right now, she can still contact the custodian of her father’s IRA and create an inherited IRA.

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all about How To

Rabu, 14 September 2016

What Is an Inherited IRA? 5 Rules You Should Know