Inheriting an IRA: Big Money at Stake

by Dick Radtke

Thirty years ago, Congress gave Americans a major tax-advantaged retirement savings tool to help us achieve long-range financial goals. Over the years, IRAs (individual retirement accounts) have grown in number and size, and in many cases have become a significant part of an estate. If you become the beneficiary of an IRA, it's important to understand the rules imposed by the IRS.

The two basic types of IRAs are traditional and Roth. Some contributions to traditional IRAs create tax deductions and others don't. None of the contributions to Roth IRAs are deductible, but Roth IRA distributions may be tax-free. All of this makes a difference when owners or beneficiaries begin withdrawing the funds. For a primer on the basic provisions of IRAs, go to IRS publication 590.

Types of beneficiaries

An IRA owner can choose anyone to receive the account after the owner's death.

Spouse beneficiaries receive special status under the tax laws. If you inherit a traditional IRA from your spouse, you have three basic options. You can:

Treat it as your own IRA by designating yourself as the account owner, Treat it as your own by rolling it over into your traditional IRA, or Treat yourself as the beneficiary rather than treating the IRA as your own.

If you inherit an IRA from a parent or someone other than a spouse, the rules become more complicated. In such cases, you cannot treat the IRA as your own. You can't make contributions or roll funds into or out of the account. But like the original owner, you are not taxed on the IRA assets until you receive distributions from it.

The trustee or custodian of the deceased's IRA may tell you that distributions must be taken in a lump sum and be subject to immediate income tax. That's not true. The tax rules give all beneficiaries payment options that allow spreading the distribution over several years. This is important because the funds in the IRA are not subject to income tax until they are distributed to the beneficiary.

A nonspousal beneficiary of an IRA has options upon receiving an inheritance. You can:

Select one of the periodic payment options offered by the trustee or custodian of the deceased's IRA. Withdraw all assets immediately. In this case, most or all of the amount you receive will be considered taxable income for that year. Talk to your tax adviser before making this decision: The more money involved, the greater the tax bite will be.

If you choose to receive payments from the deceased's IRA, you should name a beneficiary for those funds. This will allow you to pass along any remaining funds upon your death.

Plan in advance

As with most financial planning, it's wise to do some advance planning if you expect to inherit an IRA from a parent or other benefactor.

In most cases, IRA beneficiaries should be actual, named people--known as designated beneficiaries--rather than simply "my estate." It's also a mistake to leave a blank space on the IRA beneficiary form held by your financial institution with the assumption that the account automatically will be distributed to heirs as part of a will.

That's because trusts and estates have fewer payment options, and an estate has to receive the funds quickly so the estate can be closed.

The difference can be substantial. Lynn O'Shaughnessy, writing in the San Diego Union-Tribune, offers this example: "Suppose that a 45-year-old woman inherits a $50,000 individual retirement account from her mother. Instead of cashing in the IRA and paying income tax on the full amount, she chooses to stretch her withdrawals over the next 39 years, which is what the IRS says is her life expectancy. If the IRA grows at an average annual rate of 8%, she'll realize a total of $303,113 before the IRA is depleted."

If you are one of several beneficiaries of an inherited IRA--if, for example, you are sharing with siblings--ask the trustee or custodian of the IRA to separate the account as soon as possible. Each of you then can choose how to handle your own share.

More tax terms

IRAs with basis: The term basis refers to funds in an IRA upon which taxes already have been paid. If you inherit a traditional IRA from a person who had a basis in the account because of nondeductible contributions, that basis remains with the IRA. But if you are not the spouse of the original owner, you cannot combine this basis with any basis you have in your own IRA or those inherited from other individuals.

In calculating RMDs (required minimum distributions), IRA rules differ for spouse and nonspouse beneficiaries. RMDs are calculated by dividing the IRA's value (on Dec. 31) of the previous year by the appropriate distribution period. If a beneficiary misses a minimum distribution, the IRS will assess a 50% excise tax on the amount that was required to be withdrawn.

Roth IRAs

Unlike traditional accounts, Roth IRAs are not subject to distribution rules--while the owner is alive the account holder is not required to start distributions at age 70 �. And when the account holder dies, a spouse can roll the proceeds into a new or existing IRA account, owned by the spouse, and may continue to contribute to the account. There would be no requirement to take distributions.

A nonspousal beneficiary, on the other hand, must take distributions either by the end of the year marking the fifth anniversary of the account holder's death or over the life expectancy of the beneficiary, starting no later than Dec. 31 of the year following the year the account holder died. No matter how the beneficiary decides to take the Roth IRA distributions, none would be subject to the 10% early distribution tax.

By now you've probably figured out that the tax code on inherited IRAs is so complex that beneficiaries stand to gain or lose substantial sums depending on how they handle the process. If you're unsure about what needs to be done, consult an expert at your credit union or a tax specialist. Mistakes can be costly, and are not subject to reversal.

In addition to IRS publications on this subject, Montana State University offers an informative IRA publication by expert Marsha A. Goetting.

Your credit union also may be able to help with publications and counseling. And, IRA guru Ed Slott offers excellent advice in his book "The Retirement Savings Time Bomb ... and How to Defuse It."

February 7, 2005