Learning to Solve IRA Inheritance Puzzles

Baby boomers are set to inherit a lot of money – $11.6 trillion by one estimate. But if an inheritance involves an individual retirement account, tax traps abound.

The tax code complicates what should be simple. An IRA bequeathed from a spouse to a surviving spouse as a named beneficiary is relativity straightforward. But when a non-spouse is a beneficiary, complexities emerge. Ignorance of rules may result in unwelcome taxes or penalties, plus forfeiture of the opportunity for ongoing tax-advantaged growth.

Parents or grandparents, regardless of age, need to understand the rules for when a primary or contingent beneficiary of any type of retirement plan is a minor or adult child. (A contingent beneficiary receives the bequest if the primary is dead.) As advisors, we see situations where wealth transfer papers have no designated beneficiary, or they name an ex-spouse as the beneficiary or they list an estate or a revocable living trust. In each case, complications arise when you are grieving, a time of stress and loss.

If your IRA could pass to a non-spouse beneficiary, your goal is to create a stretch IRA. Ordinarily, such a beneficiary has to start taking distributions. Under stretch rules a traditional IRA passed to a child or grandchild or other non-spousal beneficiary does not have to be cashed out and taxes paid. Instead, the IRA can continue to grow and compound, potentially over a long period.

As a non-spouse, if you inherit an IRA do not comingle it with any other IRA. It must stand alone as an inherited or beneficiary IRA. You cannot add money to it as you can to an IRA of your own.

Normally, the Internal Revenue Service requires the owner of a traditional IRA to start taking required minimum distributions (RMDs) no later than April 1 following the year in which one turns age 70½. Also, distributions taken before 59½ could be subject to a 10% penalty. However, with an inherited traditional IRA, RMD rules apply even if you are under age 70½.

Generally, you have until Dec. 31 of the year following the owner’s death to take your first RMD based on a life expectancy table. For a younger person with a longer life expectancy, the RMD is likely to be less than the growth rate of the assets in the account (depending on the investment policy), hence the ability to stretch the IRA over a long period.

Contrary to popular opinion, non-spousal beneficiaries of a Roth IRA – or a Roth 401(k) – are subject to RMD rules, whereas the original owner was not. Rules are confusing. Distributions from a Roth IRA may be subject to taxation if the original account owner did not hold the IRA for a minimum of five years. Find out when the Roth IRA was established. There are options and strategies, but it is best to consult a tax advisor before making moves.

With a traditional inherited IRA, in addition to a RMD, you may take out additional money to be taxed as ordinary income free of the pre-59½ penalty. With an inherited Roth IRA, you may take out money tax-free as long as you are outside of the five-year rule. This is not wise, however, if you have other sources of money. That applies regardless of the type of IRA. Best to let it continue to grow.

If the original owner passed away before age 70½, before he or she was required to take an RMD from a traditional IRA, you may elect to use the “five-year distribution rule.” As long as you withdraw all assets by Dec. 31 of the fifth anniversary of the owner’s death, RMD penalties do not apply.

Of course, the IRS taxes withdrawals as ordinary income and you blow the stretch opportunity. If the original owner was older than 70½ and subject to RMD rules, you must continue to take distributions yourself. You may calculate RMDs based on your age or the age of the deceased in his or her year of death. This can be an advantage if the owner was younger than you.

If an IRA is split between you and siblings or other persons, separate your portion from the rest and complete your RMD by Dec. 31 of the year following the owner’s passing. If you fail to meet this deadline, you calculate the RMD based on the oldest beneficiary’s age.

Suppose you are well off, and a brother or sister or other beneficiary is in need of funds. You may elect not to inherit the assets, in which case your share is divvied up between the other beneficiaries.

Still confused? Join the crowd. Get advice before taking action.

Follow AdviceIQ on Twitter at @adviceiq

Lewis Walker, CFP, is president of Walker Capital Management, LCC in Peachtree Corners, Ga. Securities and certain advisory services offered through The Strategic Financial Alliance Inc. (SFA). Lewis Walker is a registered representative of The SFA, which is otherwise unaffiliated with Walker Capital Management. 770-441-2603. lewisw@theinvestmentcoach.com.

AdviceIQ delivers quality personal finance articles by both financial advisors and AdviceIQ editors. It ranks advisors in your area by specialty, including small businesses, doctors and clients of modest means, for example. Those with the biggest number of clients in a given specialty rank the highest. AdviceIQ also vets ranked advisors so only those with pristine regulatory histories can participate. AdviceIQ was launched Jan. 9, 2012, by veteran Wall Street executives, editors and technologists. Right now, investors may see many advisor rankings, although in some areas only a few are ranked. Check back often as thousands of advisors are undergoing AdviceIQ screening. New advisors appear in rankings daily.