A guide to inherited IRAs
There are few areas of the tax code as confusing as inherited IRAs. Let's examine your current tax deferred retirement accounts (IRA, SIMPLE IRA, SEP IRA, 401(k), 403 (b), etc) and what is required to minimize taxes from an inherited tax deferred retirement account.
The single, most important step you can take to assure that your tax deferred retirement account, which I will hereafter call an IRA, can be inherited with maximum tax flexibility is to fill out the account's beneficiary form. Contact your IRA custodian and verify that you have a named beneficiary.
IRAs Inherited from your spouse. The most flexible inherited IRA is one that is inherited from your spouse. Typically, the best approach for an inherited spousal IRA is to roll the assets into your own IRA. These assets can either be comingled with an existing IRA or put into a new IRA in your name.
Sometimes it is advantageous to set up an inherited spousal IRA instead of a rollover into your own IRA. Setting up an inherited spousal IRA may be beneficial if:
1) you are older than your spouse and your spouse died before age 70½. This option allows you to delay taking the minimum required distributions (MRDs) from the inherited spousal IRA until the year your spouse would have turned age 70½.
2) you are younger than age 59½ and you may need access to the IRA assets immediately. With an inherited spousal IRA, you may withdraw funds before you are age 59 ½ and not be subject to the 10% early withdrawal penalty that would apply if you merely rolled the funds over into your own IRA.
Whether an inherited IRA is spousal or non spousal, be sure that it is properly retitled. A suggested format is: "John Smith, Deceased (date of death), IRA F/B/O (for benefit of) Mary Smith, Beneficiary."
IRAs Inherited, other than from your spouse. If you inherit an IRA from a parent or other relative, you cannot roll it over into your own IRA. To have continued tax deferred treatment of the inherited IRA assets, you must set up a properly titled inherited IRA. The inherited IRA must be established by December 31 of the year following the year of the deceased's death.
Once the inherited IRA is properly titled, you will have two distribution options:
1) The entire IRA must be distributed by December 31 of the fifth year following the year of the owner's death. If the owner died in 2011, all of the IRA must be distributed by the end of 2016. The timing(s) of this distribution is entirely up to the beneficiary, as long as all assets are distributed by the end of the fifth year.
2) The inherited IRA can be paid out over the life expectancy of the beneficiary, starting in the year following the owner's death. If the owner is over 70½, the required minimum distribution (RMD) must also be taken in the year of the owner's death.
If the beneficiary of an IRA is a qualified trust, the two distribution options shown above apply. However, if the trust has multiple beneficiaries, the life expectancy used in option 2) must be the life expectancy of the oldest beneficiary. If the IRA is left directly to the multiple beneficiaries instead of to a trust, each beneficiary may choose their distribution option and the life expectancy distribution will be based on the age of each beneficiary.
Unless the inherited IRA has a "basis" (some of the contributions were made with after tax funds) all IRA distributions are taxable. Distributions from inherited IRAs are never subject to the 10 percent early distribution penalty, regardless of the age of the beneficiary at the time the distribution occurs.
Inheriting a Qualified Roth IRA. A beneficiary may receive all of the assets in a qualified Roth IRA as a tax free lump sum. However, a beneficiary has the option of establishing an inherited Roth IRA with the Roth proceeds. With an inherited Roth IRA, the beneficiary will only be required to take a yearly distribution, based on their current age. This allows the Roth proceeds to continue to grow on a tax free basis, throughout the beneficiary's lifetime.
Be sure to verify that all of your retirement accounts have a named beneficiary. With an inherited IRA of any type, always seek advice from a qualified professional before taking any actions with the IRA assets.
Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor, providing fee-only wealth management services. He is the author of "Financial Abundance Guide," available free at www.finabguide.com . He can be reached by email at firstname.lastname@example.org or at 303-554-0309.