Inheriting an IRA if you are not a spouse

inheritingIRAsIf you inherit an IRA (traditional or Roth) account there a number of guidelines and  key deadlines that you should be aware of.  Sound decisions can maximize the value of the account, both for yourself and for your beneficiaries.

We will be considering  inheriting an IRA  from someone other than your spouse.

Contents

Basics

If you inherit an IRA from anyone other than your deceased spouse it remains a separate account.  This means that certain transactions are prohibited.  Thus,

  • You cannot make any contributions to the inherited IRA.
  • You cannot roll over any amounts into or out of the inherited IRA into your own  IRA.

A non-spousal beneficiary of an IRA is required to make distributions from the account.  As a beneficiary  you are usually not subject to the 10% tax penalty imposed on IRA withdrawals made prior to age 59½.

A beneficiary can always take a lump sum distribution or withdraw more than the required minimum distribution (described below), although doing so reduces the tax-deferred (in the case of a traditional IRA) or the tax-free (in the case of a Roth IRA) compounding of investment returns. There are two options for deferred distribution.

  • Rule 1: The Five Year Rule– If the original IRA owner died before reaching age 70½ you can use the five year rule to receive the entire distribution by December 31 of the fifth year following the year of the owner’s death.
  • Rule 2: Lifetime Withdrawals– You can receive the entire distribution over your life, or over a period not extending beyond your life. These distributions are required minimum distributions (RMD) taken from the IRS Single Life Expectancy table (Table 1).  The table provides a divisor factor, based on the beneficiary’s age. The beneficiary divides this factor into the year end value of the IRA to determine the required minimum distribution. The divisor factor is reduced by 1 for each succeeding year. Failure to take the required minimum distribution triggers a 50% penalty tax on the amount that should have been withdrawn for the year.

For an example of how the required minimum distribution is calculated, consider that you inherit your father’s IRA account when you are 41 years old.   You begin taking distributions at age 42  so you will use the factor for a 42 year old beneficiary according to the Single LIfe Expectancy table;  this factor is  41.7.

Thus, if the year-end value of the  IRA account totaled $250,000 you would divide this total by the 41.7 factor to determine the required minimum distribution of $5995.20.

For each subsequent year the factor will be reduced by one year and applied to the year-end value of the account. Thus, if the year-end value of the account in year two is  $258,000 you would divide this value by 40.7 to determine the  $6339.06  minimum withdrawal.

Should you inherit IRA’s from more than one individual, the inherited  IRAs cannot be commingled or aggregated. Transfers between IRAs and RMD calculations must be made within each group of inherited IRAs.

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Titling and managing accounts

Executors of an estate have until December 31 of the year following the death of the decedent owner to properly title and distribute the IRA to the beneficiaries. If the deceased account owner was required to take required minimum distributions from the account, and has not paid the full RMD, it must be paid in full.

It is critical that an inherited IRA  be titled  correctly.   A failure to title the account properly as an inherited IRA, or putting the assets in your own IRA, will result  in the immediate taxation on the account’s entire value.

A typical proper titling of an inherited IRA would be the following:

“Harold Parker  (deceased April 10, 2012  IRA, For the Benefit of Thomas Parker (beneficiary). SSN xxx-xx-xxxx.”

While you cannot contribute to or roll over the inherited IRA,  you are allowed to  make a trustee-to-trustee transfer to a new fiduciary as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary. This  is extremely important, since you can move  your inherited IRA to a low-cost provider offering a full selection of investment options.

If you use multiple funds in your inherited IRA you can make tax-free transfers between funds. Although the RMD must be figured on each individual fund,  the RMD can be taken from any of the funds.

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Multiple beneficiaries

It is common for an IRA account to have multiple beneficiaries. If no action is taken to divide the IRA into separate IRAs for each beneficiary  the required minimum distribution for all beneficiaries will be  based on the life expectancy factor for the oldest beneficiary.

If the IRA is to be split, all beneficiaries must have established separate inherited IRA accounts by  December 31 of the year following the original owner’s year of death.

Furthermore, if one of the multiple beneficiaries is a charity  the IRA must pay out the charity’s share by September 30 of the year following the deceased owner’s death.

In this instance, failure to split the  IRA into shares,  including  the charitable share,  will result in the individual beneficiaries having to distribute the inherited IRA  according to the five-year rule if the  owner died before having to take required distribution; or,  if the owner died after required minimum distributions begin the beneficiaries must distribute the IRA over  the owner’s  remaining life expectancy as determined by the IRS tables.

Splitting the IRA into separate IRAs for each beneficiary provides many  advantages. Each beneficiary can:

  1. Have the option of taking required minimum distributions from the IRA over their individual life expectancy;
  2.  Select a fiduciary of choice for investing the inherited IRA;
  3.  Possess the capability of executing their own individual investment plan and account succession.

An inheritor of an IRA can, and should, name  successor primary and contingent beneficiaries to the inherited IRA.  For further succession, the inherited IRA will always retain the required minimum distribution schedule for the original inheritor.

For example,  suppose you have inherited our Father’s IRA at age 41 with a 41.7  year distribution schedule.  You name your two children,  Paul and Mary as beneficiaries.   You die at age 67.  Paul and Mary will inherit the IRA  and can take distributions over  the remaining  15.7  years of your distribution schedule.

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Special considerations concerning Roth IRAs

Under most circumstances,  withdrawals from an inherited Roth IRA will be tax-free.

However, the original account owner must have held the Roth IRA for a minimum of five years in order for earnings to be qualified for tax free distribution.

The account can be started by either contributions or conversions. The five year threshold is met on January 1 of the anniversary year. The following table provides the five year anniversary threshold for various creation dates.

Roth IRA Five Year Holding Period Requirement
First Year Roth Contribution Five Year Date
Prior to 2009 Passed requirement
2010 January 1, 2015
2011 January 1, 2016
2012 January 1, 2017
2013 January 1, 2018
2014 January 1, 2019
2015 January 1, 2020

 

 The five-year tenure requirement  can become an issue for Roth IRAs with low balances.  Fortunately, the ordering rules for Roth IRA distribution provide options for avoiding this tax on earnings.

Example

Anne Fairfax  inherits a Roth IRA from her uncle  William. The IRA was started in 2013  and has a value of $7000 consisting of $6500 of contributions and $500 of earnings. If Anne takes immediate distribution of the account she will receive the $6500 of contributions tax free. The $500 of earnings will not be subject to the 10% early withdrawal penalty, but because the Roth IRA fails the five year test, Anne will have to report the $500 of Roth earnings as a taxable distribution on her tax return.

Anne can escape taxation in this instance by only withdrawing the $6500 of contributions and retaining the $500 earnings in an inherited Roth IRA. She can use the Five Year Rule to delay distribution until the five year holding period is reached. The distribution will then be tax free.

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Complex beneficiary scenarios

nonspouse_IRAIf the IRA beneficiary is a trust, or if you are thinking about disclaiming your inherited interest in the IRA, you will need professional guidance from an estate planning specialist.

 

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Asset protection

A 2014  Supreme court  decision (9-0) ruled that inherited IRA’s are not protected from bankruptcy in federal law.

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IRS deadlines

A recap of IRS deadlines for account splitting, required minimum distributions, and disclaimers:

  • December 31 of the original account owner’s year of death. If the account owner died on or after his or her required beginning date (RBD), the RMD for the year must be satisfied if it was not taken in full during the account owner’s lifetime.
  • December 31 of the year following the original account owner’s year of death. If you are taking RMD based on the life-expectancy method, distributions must begin by this date. If you are one of multiple beneficiaries, all beneficiaries must have established separate inherited IRA accounts by this date in order to calculate distributions based upon each beneficiary’s own life expectancy.
  • September 30 of the year following the original account owner’s year of death. Important for determining the beneficiary whose life expectancy may be used to calculate RMD (the designated beneficiary). If you’re one of multiple beneficiaries of varying ages, all beneficiaries must use the life expectancy factor of the oldest beneficiary who has not taken a lump-sum distribution or disclaimed his or her entire interest prior to this date. However, if all of the beneficiaries have established separate IRA accounts by December 31 of the year following the account owner’s death, then all beneficiaries may be able to use their own life expectancy factors to calculate their RMD. Check with your tax advisor to see if you are eligible for this benefit.
  • October 31 of the year following the account owner’s year of death. Important if you are the trustee of a trust named as IRA beneficiary. The IRS mandates that trustees provide the fiduciary with a copy of the trust document or a summary list of the trust’s beneficiaries and conditions by this date. If this requirement is not met, or if the trust failed to meet certain other IRS requirements, it’s not considered a qualifying trust eligible for more favorable RMD calculations, usually based on the life-expectancy of the oldest trust beneficiary.
  • Within nine months after the original account owner’s death. If you’re planning to disclaim the assets, your written disclaimer generally must be received no later than nine months after the date on which you become entitled to the assets, according to IRS regulations.

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About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

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