In the movies, getting an inheritance always seems like a straightforward affair. There’s a knock at the door and a lawyer wearing a flashy suit hands the stunned recipient the keys to an estate or a check for millions. But the fact is that if you were to receive an inheritance these days, it would likely be in the form of an IRA, which makes the process anything but simple.
What Happens First?
Note: For the bulk of this article, we’re going to assume the IRA you’ve inherited is from anyone other than a spouse, as different rules apply to spousal inheritances (see below).
Prior to receiving the IRA funds, you should work with a financial advisor to ensure all paperwork is done correctly. The first step is retitling the account which should be named as: “John Doe, Deceased (date of death) IRA F/B/O Your Name, Beneficiary.” (F/B/O stands means “for benefit of.”) Second, it’s important that the funds from the inherited IRA be kept in a separate account and that even different types of inherited IRAs remain separate. For example, you can’t combine an inherited IRA with an inherited Roth IRA. Finally, you need to make sure the funds from the inherited IRA go directly into the new account because—unlike regular IRAs where you can take out funds tax-free as long as they’re returned within 60 days—the minute you take funds from an inherited IRA, they are taxed.
What Can I Do With The Funds?
You basically have three options when you inherit an IRA: you can cash it out and take the money as a lump sum, you can disclaim it, or you can “stretch” the IRA and take regular annual payments over the course of your lifetime.
Cashing out. This is the simplest option of all, but might not be the smartest. That’s because when you take the cash, it is immediately added to your income and taxed accordingly. Depending on your earning situation, this means you could be catapulted into a higher tax bracket and pay heavy income tax on the liquidated IRA money. On the other hand, cashing out an inherited IRA does not subject the money to the 10 percent early-distribution penalty assessed to regular IRAs taken before the age of 59 1/2. Be sure to report the funds on IRS Form 1099-R as “death distributions” and use code 4 in Box 7.
Disclaiming. Taking this action means that you tun down the IRA entirely. Why on earth would anyone choose to decline free cash? Depending on the size of the IRA and your earnings, you might find that the tax levied on the distributions outweigh the benefit of receiving them. You might also be in a situation where creditors could be entitled to the distributions. But the most likely situation in which you would disclaim an IRA inheritance would be to pass it along to your children, who could enjoy the tax-deferred growth of the money for many years. If you choose to disclaim an inherited IRA, you must do so within nine months of the benefactor’s death.
Stretching the IRA. This means leaving the money in the newly created IRA and only taking small required distributions every year. To determine the amount of the annual distribution you are required to take, divide the account balance by your life expectancy figure provided by the IRS in publication 590. The benefit here is that the money will continue to grow tax deferred for as long as wish, yet you can always decide if and when you’d like to take more in any given year. It gives you the flexibility to take more cash in a low-earning year or during your own retirement to keep your tax liability low. An important thing to note here is that in order to exercise this option, the IRA must have been set up correctly in the first place: to a custodian or trust that allows stretching. If it wasn’t set up that way, you must first move the funds to an account that allows stretching by using a trustee-to-trustee transfer. Also, should you go this route, you must begin taking your annual distributions by December 31 in the year following the original owner’s death or you can be slapped with a 50 percent IRS penalty on the shortfall.
Anything Else I Should Know?
Estate Tax. Be sure that you are aware of the federal estate tax implications for the IRA you inherit. In 2013, any estates over $1 million will be subject to estate tax unless congress votes to keep the level where it is—estates over $5.12 million. However, what’s important to note here is that if an IRA is split between multiple recipients, as long as one of them pays the required estate tax, all recipients can apply the deduction against their inheritance through something known as “income in respect of a decedent.”
Year-of-death distribution. If the original owner of the IRA passed away after she was 70 1/2, you must take her required minimum (RMD) distribution in the year of death. Otherwise, the 50 percent IRS penalty will apply.
Roth IRAs. If the money you inherit comes in full or in part as a Roth IRA, check with your accountant to understand the potential tax benefits you can enjoy if the account is handled property. The rules are slightly different for these types of accounts as the cash originally deposited in them was done so on a post-tax basis.
Spousal inheritance. If you are a spouse who has received an inherited IRA you may also choose to take a lump-sum payout or open an inherited IRA, but you have the additional option of transferring the funds to your own IRA. If you choose to open an inherited IRA, you must start taking the account holder’s RMD if he was under age 70 1/2 at time of death. If the account holder was over 70 1/2, your RMDs follow the same rule as all inherited IRAs.
Useless Triva. IRA stands for Individual Retirement Arrangement, not Individual Retirement Account as often believed.