I Just Inherited an IRA, What Should I Know?

The rules of an IRA may seem simple: you make contributions to a retirement account that is created with a custodian such as Charles Schwab or TD Ameritrade, the account grows tax deferred (unless it is a Roth IRA, in which case it grows tax-free), and you are taxed at your ordinary income tax rate upon withdrawal (again, unless a Roth IRA). At death your IRA will pass to the beneficiaries that you listed. Simple right?

If you own an IRA, at some point your advisor will likely talk to you about Required Minimum Distributions, Required Beginning Dates, ROTH Conversions, IRA Recharacterizations, Non-deductible contributions (which can be an excellent gateway for higher income earners to contribute to a Roth IRA), Stretch IRAs, IRA Rollover rules, and of course the focus of this article: inheriting an IRA.

As with most areas of the U.S. Tax Code, there are many IRA rules; some of which are complex and some that do not make logical sense. Likely due to this complexity, we often see instances where inheritors of IRAs have acted to their detriment based on bad information. The actions one should take with regards to retirement accounts are not always obvious at the surface, and are best uncovered while weighed in relation to the overall financial picture of the individual or family involved. As such, a comprehensive financial plan should be a part of the decision making process and consulting with a competent financial planner and income tax professional is highly recommended.

As you will discover as you read through this article, the most advantageous action to take with Inherited IRAs will be determined by your relationship to the deceased, their age, your age, your income tax circumstances, and your financial objectives. In other words, as with most topics in personal finance, there are a lot of moving parts to be addressed in order to maximize your Inherited IRA’s financial utility, and the “right” answer for one person may be very different than the “right” answer for another.

When the IRA was established by the Tax Reform Act of 1986 baby boomers were between the ages of 22 and 40 (1946 - 1964 according to the US Census Bureau). In 2014, baby boomers are now in the age range of 50 - 68. A large transition of wealth to the next generation has already begun. Many people have already inherited IRAs and we are starting to see more people inheriting Inherited IRAs. The following are just a few important considerations when inheriting IRAs and inheriting Inherited IRAs.

If you inherit an IRA as a spouse and the account holder was under the age of 70 ½ when they died, you have the ability to:

• Roll over the inherited assets into your own new or existing IRA (in other words, treat it as your own).
• Transfer your inherited assets into an inherited IRA. Required Minimum Distributions must begin by December 31st of the year the account owner would have turned 70 ½. Alternatively, you can elect the “5 year rule”, after which the entire account must be withdrawn from your Inherited IRA by December 31st of the fifth year after the year the account owner died. As yet another alternative, one can elect a lump sum distribution. The normal 10% penalty does not apply to these distributions if you are under the age of 59 ½, however the distributions are subject to income tax.
• Roll over and convert inherited IRA assets to your own Roth IRA (paying the tax now but receiving tax-free distributions later, or creating an excellent tax-free asset to pass to the next generation).
• Disclaim all or part of your inherited assets (for estate planning purposes).

If you inherit an IRA as a spouse and the account holder was over the age of 70 ½ when they died, you have the ability to:

• Roll over the inherited assets into your own new or existing IRA (in other words, treat it as your own).
• Transfer your inherited assets into an inherited IRA. Required Minimum Distributions must begin by December 31st of the next year following the death of the original owner. If the original owner did not take their RMD for their year of death, you must take that RMD. As an alternative, you can elect a lump sum distribution. The “5 Year Rule” is NOT available in this scenario. The normal 10% penalty does not apply to these distributions if you are under the age of 59 ½, however the distributions are subject to income tax.
• Roll over and convert inherited IRA assets to your own Roth IRA (paying the tax now but receiving tax-free distributions later, or creating an excellent tax-free asset to pass to the next generation).
• Disclaim all or part of your inherited assets (for estate planning purposes).

If you inherit an IRA as a Non-Spousal beneficiary and the account holder was under the age of 70 ½ at their death, you have the ability to:

• Transfer your inherited assets into an inherited IRA. Required Minimum Distributions must begin by December 31st of the year after the account owner died. Distributions will be determined by your age in the year following the death of the original IRA owner, recalculated annually, and can be spread out over your lifetime. Alternatively, you can elect the “5 year rule”, after which the entire account must be withdrawn from your Inherited IRA by December 31st of the fifth year after the year the account owner died. As yet another alternative, one can elect a lump sum distribution. The normal 10% penalty does not apply to these distributions if you are under the age of 59 ½, however the distributions are subject to income tax.
• The IRS does NOT allow for Non-Spousal beneficiary to convert an Inherited IRA into a Roth IRA. As an aside, you do have the ability to convert an inherited qualified plan to a Roth IRA (paying the tax now but receiving tax-free distributions later, and creating an excellent income tax-free asset to pass to the next generation).
• Disclaim all or part of your inherited assets (for estate planning purposes).

If you inherit an IRA as a Non-Spousal beneficiary and the account holder was over the age of 70 ½ when they passed away, you have the ability to:

• Transfer your inherited assets into an inherited IRA. Required Minimum Distributions must begin by December 31st of the next year following the death of the original owner. The rules are the same as the above scenario where the original account owner was under age 70 ½; with the additional requirement that if the deceased did not take their RMD in the year they passed away, you must take that RMD. As an alternative, one can elect a lump sum distribution. The “5 Year Rule” is NOT available in this scenario. The normal 10% penalty does not apply to these distributions if you are under the age of 59 ½, however the distributions are subject to income tax.
• As mentioned in the section above the IRS does NOT allow for Non-Spousal beneficiary Inherited IRA ROTH conversions, however you do have the ability to convert an inherited qualified plan (paying the tax now but receiving tax-free distributions later, or creating an excellent tax-free asset to pass to the next generation).
• Disclaim all or part of your inherited assets (for estate planning purposes).

If you inherit an Inherited IRA, your options are limited even further. For example:

• Unlike a non-spousal beneficiary Inherited IRA where the distributions are based on their life expectancy, as an inheritor of an Inherited IRA you have to continue the distribution schedule of the deceased person you inherited the account from. Alternatively one can take a lump sum distribution (and pay the income taxes on the lump sum).

If you inherit a ROTH IRA there is an additional consideration:

• • For spousal and non-spousal beneficiaries, any withdrawals of earnings taken prior to the point at which the original owner would have satisfied the 5-year rule will be subject to income tax on the amount exceeding the tax basis, or earnings, of the account. The 10% early withdrawal penalty for under the age of 59 ½ does not apply.

In addition to the previously stated rules, here are other important considerations when dealing with Inherited IRAs and inheriting Inherited IRAs:

• Do not assume that your wealth manager, broker, insurance agent, custodian, or accountant knows the rules. We are currently helping a new client who is inheriting Inherited IRAs from multiple custodians (brokerage firms). One of the custodians instructed the client that they were required to take a lump sum distribution. This “advice” would have resulted in a 46.6% (39.6% Federal and 7% State) income tax on the distribution. The client actually has the ability to stretch the IRA distributions on the same schedule as the deceased, and taking this action is much more aligned with their financial goals.
• If there are multiple beneficiaries of an IRA, separate accounts must be established by 12/31 of the year following the year of death otherwise distributions will be based on the oldest beneficiary's life expectancy. For example, if you have a 90 year old beneficiary and a 10 year old beneficiary, the 10 year old would be forced to take distributions on the 90 year old's life expectancy, creating unnecessary taxable income for the child. While an extreme example, most people dramatically underestimate the value of a lifetime of tax deferral on an investment account.
• When naming the beneficiaries of your accounts, understanding the rules of inherited IRAs can help maximize the value of the inheritance. For example, we are working with a family who is inheriting assets from another non-spouse family member. The deceased named the brother as the beneficiary of his IRAs and the niece as the beneficiary of the Inherited IRAs. In this case, the brother will take distributions based on his life expectancy, whereas the niece has to finish out the distribution schedule of the deceased. Ideally the brother would have named the niece as beneficiary of the IRAs and the brother as beneficiary of the Inherited IRAs. This would have allowed the brother to continue the deceased’s distribution schedule which is similar to his since they were close in age. The niece would have been able to stretch the distributions over her life expectancy which is significantly greater thus preserving the benefits of tax deferral. As mentioned in the paragraph above, the costs of the loss of this tax deferral over a child’s lifetime can be substantial. Lake Tahoe Wealth Management consistently preaches that all areas of your financial plan are linked, and here is an example of linked retirement, estate, and income tax planning that could have been avoided with a simple annual review of the estate plan and beneficiaries.
• If you don’t follow the IRS distribution rules appropriately, and for example, you forget to take your $10,000 Inherited IRA distribution this year, the IRS will levy a 50% penalty on the amount that was supposed to be distributed. In this example, a $5,000 penalty.

The IRS mandated distribution schedule is dependent upon variables such as the age of the deceased, your age, and your election. Your wealth manager should help you determine the best election for your situation.

If this article has raised questions about how your IRA accounts, or those of family and/or friends are being handled, contact Lake Tahoe Wealth Management at 607-382-7780 today. The costs of mistakes with retirement accounts can be severe and the impact can last multiple generations. Ensure you are working with a Professional who understands more than just the IRA rules in isolation, but how the rules interrelate with all aspects of your family’s multi-generational financial picture.

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