Whoopee, your great aunt died and left you her Individual Retirement Account (IRA). The first thing you want to do is cash the check and take the family out to dinner. Wrong! The first thing you should do is read the rest of this column.
An inherited IRA can be a tricky. It requires some knowledge of estate, financial and tax planning. If you are not familiar with any of the above concepts, meet with a financial advisor or send me an e-mail. You see, one wrong decision can have expensive consequences. For most people, the worst thing you can do is cash out the plan before seeing an advisor.
Know this: the money in an inherited IRA must be taken out eventually. How much and how soon depends on a number of variables. The best case scenario tax-wise and (probably worst emotionally) is that you have inherited an IRA from your deceased spouse. In this case, there are no tax consequences and you are not required by the IRS to withdraw taxable distributions until you reach the age of 70 ½.
But let’s say that you are a non-spouse and the money came from your great aunt. You have two options: you can choose to take distributions over your life expectancy. It is called the “stretch” option and would allow the remaining funds in the IRA to grow tax-free for as long as possible. Each year the required distribution, which is computed based on a life expectancy table generated by the IRS, is taxable at your current income tax bracket.
The second option is to liquidate the account within five years of the original owner’s death. That means that if the IRA is worth $100,000 when you received it, you can take it all out whenever you want. There are two negatives to that strategy. You could pay a whopping tax bill on the distribution and you would also forfeit the option of allowing the money in the IRA to continue to grow on a tax-free basis. If you are careful and invest wisely, you could see your inherited IRA continue to grow. Conceivably, that IRA could be inherited by your decedents when you pass. By the way, children of the deceased are subject to the same rules as anyone else. Only a spouse is exempted.
“What if the inherited IRA is a Roth?” you might ask.
Since a Roth IRA is funded with after-tax contributions, distributions from an inherited Roth IRA are tax-free unless the account was established less than five years before his/her death. In that case, the earnings generated from contributions may be taxable. A spouse will never be required to take a distribution from an inherited Roth.
There are a few quirks, however, that you should understand. A Roth and a Traditional IRA are different animals as far as the IRS is concerned. You can’t merge the two. As a spouse, you can roll your spousal inherited IRA into your own and are only required to take a minimum required distribution (MRD) on the total at age 70 ½. If you are a non-spouse, you can’t merge an inherited IRA with an existing IRA that you own, nor can you merge an inherited Roth with your own Roth.
And before you automatically leave your IRAs to the beneficiaries of your choice consider this. Leaving an IRA to an older individual doesn’t get them much. If the beneficiary is closer to retirement age or even older, they will be required to withdraw money far sooner than your grandchild, for example.
You might also have a beneficiary who goes through money as if it were water. For those spendthrifts, a $100,000 inherited IRA is an invitation to disaster. They will spend the money first and worry about the taxes later—when they are broke!
Although it sounds intelligent, naming your “estate” as the beneficiary of your IRA may not be wise either. You could potentially lose creditor protection of the IRA, force your beneficiaries to only take the five-year withdrawal rule while increasing legal and accounting fees. It could also increase the time and complexity of your probate estate.
But whatever you do don’t procrastinate; the clock is also ticking once you inherit an IRA. In order to choose the ‘stretch’ option, you must take your first distribution no later than December 31 of the calendar year following the year that the decedent died. If you fail to take that first distribution by then, you will be required to take the five-year option.
Remember also that if you forget to take your MRD each year, the IRS will penalize you by taking half of it every year that you don’t. The moral of this tale is to enjoy your inheritance, but do so wisely.