“Nightmares of Inherited IRAs”
11/19/06
Last week, I discussed year end planning steps if you are over age 70 ½ and have one or more retirement accounts. But, what must you do if you have inherited an IRA? Depending on the circumstances, the rules are equally complex and the penalties for not following the rules can be substantial. Let’s look at some of the more common situations and the strategies to handle them.
The easiest situation is when a spouse is the beneficiary of deceased spouses’ retirement account. In most cases, the surviving spouse will simply ‘roll-over’ the retirement account into his or her account without tax consequences. There is a little-known tactic that is helpful under certain circumstances. If the surviving spouse is under age 59 ½ and needs access to the IRA for any reason, by accepting the IRA as an inherited IRA rather than a Rollover IRA, the surviving spouse can take withdrawals without having to pay the 10% federal early withdrawal penalty.
If you inherit retirement funds from anyone other than a spouse, you are required to take distributions under one of the following rules. You can elect to either:
1. Begin taking Required Minimum Distributions (RMDs) by December 31st of the year following the year of death of the IRA owner or
2. You can withdraw the funds at any pace you choose so long as 100% of the funds are withdrawn within five years of the year in which the owner died.
If you choose election #1, your RMDs are based on your life expectancy using the federal Single Life Table. Withdrawing the minimum required under this approach allows you to ‘stretch’ the tax payments over as long a time as possible.
Here’s another little known tactic. Often parents will name their children as the beneficiaries of their IRA or other retirement accounts. Let’s say the children are ages 37, 31, 27 and …oops…age 16. Under election #1 above, the RMD for all of the children is based on the life expectancy of the eldest child, age 37 in this example. All of the younger siblings must take higher distributions than would have been the case if each had been the sole beneficiary. To avoid this, the beneficiaries must ‘split’ the IRA into separate inherited IRA accounts prior to December 31st of the year following the year of death of the IRA owner.
Does all of this sound complicated? It is…and the penalty for making a mistake can cost you 50% of the amount you should have taken. Certain violations can cause the entire retirement account to be a deemed distribution causing current year taxation on the entire account. That’s why it’s important to be careful and seek professional assistance when needed.