Inherited an IRA? Watch Out for These Possible Pitfalls
Time was, if you were fortunate enough to inherit something, it typically was in the form of a parent's home, possibly some land and maybe a bit of cash. Increasingly, however, inheritances are in the form of Individual Retirement Accounts (or IRAs), especially as Boomers age and transfer wealth.
If you find yourself in the position of inheriting an IRA, don't make any sudden moves because such accounts come with pitfalls you need to know about before doing anything. And better yet, seek professional financial advice earlier rather than later.
One of the worst things you can do is just cash it in and then see what happens. By then, it's most likely too late to fix any potential problems or take advantage of certain benefits in the tax code.
What follows are some tips to help you navigate this tricky area.
Surviving Spouse: If you are a surviving spouse who is inheriting the IRA, the rules are very beneficial for you. Basically, you can take the IRA and treat it as if it is your own (and always has been).
Why is this important? Spouses, first of all, are not subject to the five-year payout rule (discussed later) and generally may delay taking distributions much longer than non-spouse beneficiaries.
For instance, a spouse may wait until he/she reaches age 70½ before being required to begin distributions from a traditional IRA, and such distributions may then be taken over the combined life expectancy of the spouse and the next beneficiary.
If the IRA is a ROTH, you as the spouse would never be required to take distributions if not desired, allowing the account to grow tax-free for the rest of your life and then left entirely to your beneficiaries. And spouses can name their own beneficiaries, giving further flexibility.
Here's the wrinkle; to take advantage of these benefits, you have to rollover the IRA into your own name, not leave it in the name of the deceased, a step often missed.
Nonspouse Beneficiary: The news isn't all bad here, although it can be if proper steps aren't taken.
Generally, the IRA inherited by a nonspouse beneficiary must be eventually distributed. The critical question is how fast must it be taken out, and that depends on the steps taken after death of the original owner.
Basically, you have two options here.
First, you can liquidate the account completely within five years of the original owner's death. This is the default option that kicks in if nothing else is done, and for large accounts can result in a hefty up front tax bill unless the IRA is a qualifying Roth IRA. The reason for the tax being so onerous? Because large distributions can easily push you into tax brackets much higher than in what you would normally be or would be the case if smaller distributions could be taken over a longer period of time.
A way around this is by choosing the option to take distributions over your life expectancy, commonly referred to as the stretch option, or stretch IRA. This literally gives you the ability to leave the money growing on a tax-deferred basis (or tax-free if a Roth IRA) for years upon years, if not decades, while potentially saving you a large amount on your tax bill.
It is important to note here that waiting too late to put this option into effect can be costly. In order to use the stretch IRA option, you have to take yearly required minimum distributions (known as RMDs) based on your own life expectancy.
The timeliness of your first RMD is critical, as you have to take that first distribution by December 31 of the calendar year following the year that the original owner died. Missing that date is costly, as you default back to the five-year rule discussed earlier. Other Potential Issues: Although space limits discussion of these, there are some other issues of which you should be aware.
For instance, if the original owner was over age 70½ and the account is NOT a Roth IRA, you will have to determine if the owner took out their RMD prior to death, and if not you will be required to do so. Failure to get this done makes you liable for a 50% penalty. Second, make sure you are dealing with advisors and IRA custodians who are familiar with this area of the law, since a slip up on their part can lead to something you may not want but cannot be undone. If you have concerns or receive conflicting advice, be sure to get that resolved before signing anything even if it means getting a second opinion.
And finally, an improper beneficiary designation (or a missing one) can lead to disastrous results. Be sure any IRAs you own have proper specific beneficiary designations, and if you know you are the intended beneficiary on an IRA of someone else, you may want to check on that also. This can save many a headache and lots of money later on.
Moral to the story: never rush to make decisions or cash out an inherited IRA, but beware the deadlines and seek good advice from an expert!
