Inherited IRAs
When inheriting an IRA from a friend or family member, it is important to understand the special rules that apply to these accounts and the options that are available to you as a beneficiary. The decisions you make early on with inherited IRAs can have a significant impact on both the tax implications for you individually, as well as the lasting legacy that these inherited accounts create for beneficiaries.
Inherited IRA Rules
When dealing with inherited IRAs, it is important to understand the IRS rules that differentiate these accounts from other IRA accounts that you might have been contributing to personally. The main differences are as follows:
1.) Inherited IRAs cannot be commingled with other IRAs - Nonspouse inherited IRAs must be held in a separate account from the beneficiary’s personal IRA accounts, as well as any other inherited accounts from other individuals. If you inherit an IRA from your mom, your dad, and you have your own IRA that you’ve been contributing to personally; all three must remain separate accounts and cannot be combined into one account. There is, however, an exception to this rule for spousal beneficiaries, which we will cover later on in this post.
2.) Transfer options for inherited IRAs are limited - While you are still allowed to do a trustee-to-trustee transfer directly from one IRA custodian to another (i.e. if you wanted to move the account from Fidelity to Vanguard), there is no 60 day rollover option that is usually available with normal IRAs. If the custodian sends you a check for the money, then it is considered taxable income in the year sent to you and is ineligible for redeposit in the inherited IRA.
3.) Inherited IRAs may not be converted into Roth IRAs - Unlike your personal IRAs, inherited IRAs cannot be converted into a Roth IRA.
4.) Nonspouse inherited IRAs do not have bankruptcy protection - Personal contributions to an IRA, as well as any rollovers from a 401(k) or other employer-sponsored plan, are protected assets during bankruptcy proceedings. Inherited IRAs for nonspouse beneficiaries do not enjoy these same protections.
5.) You will be penalized by the IRS if you do not annually pull enough money out of your inherited IRA account - The IRS wants their money. If you do not pull out the proper amount of money out of these accounts each year (as outlined below in the options section), then you will be assessed a 50% penalty on the amount that you were supposed to withdraw for the year (if you were supposed to pull out $4,000 but didn’t make any withdrawals, then you will be assessed a $2,000 penalty). It is important to note that this applies to both inherited IRAs and inherited Roth IRAs!
Inherited IRA Withdrawal Options
Nonspouse beneficiaries generally have three options that they can choose between on how to withdrawal the money, while spousal beneficiaries have four options that they may choose between. These are as follows:
Option #1: Lump-Sum Withdrawal
The first option available to beneficiaries of inherited IRAs is that they may choose to withdraw the entire balance of the account in one lump-sum upon inheriting the money. While this might be a perfectly reasonable option for small inherited accounts whose sum is a few thousand dollars, this is typically not an optimal solution for larger inherited accounts due to the tax consequences of this transaction. While these withdrawals avoid the 10% early distribution penalty that are usually assessed upon IRA distributions before age 59 ½, all distributions are considered taxable income in the year that they were withdrawn from the account. Thus, if someone were to cash-out an inherited IRA in one year, he/she could end up paying 32-37% federal income tax on that money!
Option #2: Withdraw All Funds Out of the Account within Five Years
If the account value is too big to fully cash-out in one year, the IRS allows the beneficiaries of an inherited IRA a five-year window (beginning on January 1st of the year immediately following the year in which the original account owner passed away) to withdraw all of the money out of the account. Equal amounts do not have to be taken out each year, the IRS only wants all of the money out by the end of that window. As with option #1, the distributions from the IRA is considered taxable income in the year the money is withdrawn from the account, but it avoids the 10% early withdrawal penalty.
Option #3: Stretch IRA
Probably the most popular option (and usually the best option) is to transfer the inherited monies into an inherited IRA account that is held in your name (this account is not to be comingled with your personal IRA contributions or other inherited IRAs from other individuals). Using a single life expectancy chart provided by the IRS, you may “stretch” the withdrawal period over your expected lifespan. There is no limit to how much you may withdraw in a given year, rather, the IRS only outlines the Required Minimum Distribution (RMD) that you must withdraw annually to keep from being penalized by the government.
For a beneficiary that is still in their early-to-mid working years, the stretch option can be incredibly powerful, as it allows the assets in the IRA to continue to grow tax-deferred for as long as possible. Instead of having to pull all of the money out of the account in five years or less, a fairly young beneficiary may be able to make stretch the withdrawal period over 40+ years!
To calculate the RMDs that you will need to withdraw in a given year, take your age on December 31st of the year following the original IRA owner’s death and find the corresponding life expectancy on the IRS’ Single Life Expectancy Table. Then, divide the account balance as of December 31st of the previous year, by the IRS Life Expectancy number. The resulting number will be your Required Minimum Distribution for the year. Each year thereafter, subtract one from your life expectancy for the previous year and divide once again by the account value on December 31st from the previous year to find your new RMD for the year.
Example
Fred inherits an IRA from his father with an account balance of $425,000 on December 31st the year that he passed away. Fred is 35 years old on December 31st the following year. Fred’s life expectancy is 48.5. Thus, Fred’s RMD for the year after his father passes away is calculated as follows:
$425,000 divided by 48.5 is $8,762.89
The following year, the value in the account has risen to $440,000. Fred’s life expectancy is now 47.5. Fred’s RMDs for the following year is calculated as follows:
$440,000 divided by 47.5 is $9263.13
Option #4: Treat the IRA as your Own (only available for spouse)
A beneficiary who has inherited an IRA from a deceased spouse may, in addition to utilizing any of the previously mentioned options, consider one more option that is not available to nonspouse IRA beneficiaries. If they so choose, they may either claim the IRA as their own or roll the proceeds of the account into one of their own IRAs. This is generally only recommended for spouses who are 59 ½ or older, as once the money is claimed by the spouse, then the 10% early distribution penalty applies, as per usual.
Conclusion
When inheriting an IRA, it’s important to understand all of the options that are available to you. The decisions that you make upon first inheriting the account can have substantial tax and legacy consequences. If you have an IRA that you’ve inherited in the last few years and want to have a more detailed discussion on what is the best course of action for you personally, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
