IRAs are a popular and widely used tax benefit. Yet, they are fraught with tax traps and complicated transfer rules, making the unaware subject to unexpected and potentially high taxes and penalties. Here are some things to be aware of when you inherit an IRA from a deceased loved one.
- The title of inherited IRAs should remain in the name of the deceased, with the name and Social Security number of the beneficiary added to it. This procedure is typically used when the beneficiary is a nonspouse. A sample title would be:
Alfred Washington, deceased (date of death, December 14, 2016), for benefit of Barbara Curtis (Soc. Sec. # 987-65-4321) beneficiary.
Changing the name of the deceased’s IRA other than as described above in point #1 is considered a taxable distribution for the entire value of the IRA.
- Rollovers of an IRA from a deceased owner can only be made to a spouse. They cannot be made to anyone else. The surviving spouse can either transfer it to his/her own IRA or change the name of the deceased’s account to her name and that would constitute a rollover. If it is rolled over to the surviving spouse’s IRA, then it is treated as if it was always the surviving spouse’s account and the surviving spouse’s RMD rules apply. If the surviving spouse adds her name as described above in point #1 for a non-spouse she must take required minimum distributions (RMD) the same as a non-spouse (see point #3 below).
- A rollover by a non-spouse is considered a distribution to him and the entire value of the IRA would be taxable.
- An inherited IRA can be disclaimed by the designated beneficiary. This is a strategy to have the IRA pass to contingent beneficiaries and bypass the designated beneficiary. For this to be done, there has to be no changes in the account title or distributions beforehand. One reason to do a disclaimer is to pass the IRA to a younger beneficiary, permitting a longer distribution period because of his/her longer life expectancy. Disclaimers are extremely technical and need professional guidance.
- Once it is decided who inherits the IRA, distributions will need to be made. There are different ways of calculating the RMD depending upon whether the owner died before or after his required beginning date (April 1 of the year following the year the owner attained age 70 ½). In either event, the distributions must start by the end of the year following the year of death. And in both situations, the age of the beneficiary in the year following the death determines the RMD. If the beneficiary is older than the deceased, different rules can apply.
- If there are multiple beneficiaries, the life expectancy of the oldest beneficiary is used to determine the RMD for all beneficiaries. They have until September 30 of the year following the year of death to determine who the designated beneficiaries are…and then until December 31 of that year to split the inherited IRA into portions for each designated beneficiary. They could then each use his/her own life expectancy for the RMD. Be careful to change the title correctly (see point #1 above).
- If one of the beneficiaries is a charity and/or the estate and the IRA is not divided, then there is deemed to be no life expectancy and the distributions must be taken either in full within five years after the death if the owner died before their required beginning date, or based on the owner’s life expectancy if the death was after the required beginning date. The best way to handle this is to make a full distribution to the charity and/or estate by September 30 in the year following the year of death. Note that while the estate can be a beneficiary, it would be wrong and terrible, since it would all be taxable.
- There are no withdrawal limits. While there are RMD amounts, distributions are permitted in any amount greater than this up to and including the entire IRA account balance. Excess distributions in one year do not offset RMDs in later years. Each year must have distributions of the full RMD amount.
- All beneficiaries, except charities, are taxed on the distributions they receive. A strategy for IRA owners that want to leave funds to a charity is for them to have the charity receive it directly from the IRA rather than from other assets. Note that there is no step up on basis for IRAs as there are for capital assets.
- IRAs are included with a decedent’s assets are can be subject to estate tax. To the extent there is an estate tax paid by the estate, the beneficiaries would be entitled to an income tax deduction (on Schedule A and not subject to the 2 percent limitation) for the portion of the federal estate tax that was attributed to that year’s taxable income reported by them.
- If the owner died and did not take his RMD in that year, the beneficiaries must take it before the end of the year, or by April 1 of the next year if applicable. If this is not possible then it must be taken as soon as possible thereafter. This withdrawal is taxable as income to recipient but not subject to estate tax. If the withdrawal were not taken, it would be included in the IRA and subject to estate tax.
The above are some of the complex tax rules for what should be a simple process. A caution is that it is advisable to consult with a financial professional familiar with taxation of inherited IRA accounts.
For more information, check out Edward Mendlowitz’s website, or click here to purchase his book, Managing Your Tax Season.