Just over one-third of American households rely upon the tax benefits of an individual retirement account to help fund their golden years. Nobody likes to think about an account owner passing away before that retirement runs its course. At the same time, when that happens, beneficiaries need to understand the rules well enough to make good decisions about their inheritance.
What You Need to Know About an Inherited Individual Retirement Account
As an IRA beneficiary, your choices will depend upon your relationship to the deceased account owner. If you're a spouse, you have more choices than people with other relationships to the original owner.
Inheriting a Spouse's IRA
According to the IRS, a spouse can simply assume ownership of the IRA, roll it into another qualified account, or choose to be treated as a beneficiary and not an owner. Typically, neither spouses nor other beneficiaries will owe taxes until they receive distributions; however, spouses can choose to either:
- Delay distributions of traditional IRAs until the deceased owner would have turned 70 1/2 years old OR
- Treat Roth IRAs as their own and start distributions at any time
For instance, you might choose to simply treat the IRA as if it was always yours. In this case, you can still enjoy the tax deferred growth of the account. If it's a traditional IRA, you'll need to wait until age 59 1/2 to take out money without a penalty. You must start distributions by 70 1/2.
Particularly if you're still considerably younger, you may opt to follow the non-spouse beneficiary rules. Naturally, you'll still get taxed on distributions, but you won't have to pay the early withdrawal penalty.
Inheriting an IRA From a Non-Spouse Owner
If you inherited an IRA from a parent, grandparent, or anybody besides a spouse, you can't simply assume ownership of the individual retirement account. You can create your own inherited IRA and transfer the funds into it. With inherited IRAs, you can't make contributions. You also have to begin taking your minimum distributions by the end of the year after the original owner's death.
Luckily, the IRS doesn't charge any early-withdrawal penalties; however, they do have rules about required distributions, and any payments you receive from traditional IRAs can incur an income tax bill. Furthermore, failing to take a required distribution can cost you more in penalties than typical income taxes.
Basically, you can choose one of three distribution strategies with a traditional IRA:
- Simply forgo setting up an IRA and take a lump sum. Some people prefer to simply pay the taxes and use the money.
- You can withdraw all the money over a five-year distribution period. You don't have to withdraw a specific amount in any one year, but you need to have emptied the account after five years.
- Make withdrawals according to a life-expectancy distribution. Divide the total balance by the life expectancy factor on this table, based upon your own age to calculate the amount you need to withdraw each year. For example, if you're fifty, you would divide the total by a life expectancy factor of 34.2. This method may allow you to stretch out distributions in order to also spread out your tax bill.
You always reserve the option to withdraw more than your required minimum distribution. If you fail to withdraw at least the RMD, the IRS can penalize you 50 percent of the amount you failed to withdraw. For instance, if your RMD was $2,000, and you only took $1,000, the government can collect $500.
Since contributions into a ROTH IRA weren't tax deferred, you also won't need to pay income taxes upon withdrawals. Original owners and spouses also don't need to take minimum distributions. Non-spouse beneficiaries need to accept distributions based upon one of the three methods used for traditional IRAs. However, so long as the money has been kept in the account for at least five years, withdrawals won't generate tax bills.
Why is Timing Beneficiary IRA Distributions Important?
As you can see, it's important to consider your distribution strategy when you inherit an IRA. Your timing can impact the account's growth, your total inheritance over time, and of course, your tax bill. You will certainly want to withdraw at least any required minimum distributions to avoid a hefty penalty.
Here in Charlotte, NC, Scott Boyar CPA has helped plenty of clients understand the financial implications of such important decisions as taking distributions from retirement accounts. Call or email me with your questions to learn how to maximize your returns and minimize taxes.