About 44 million U.S. households held at least one individual retirement account as of 2017, with a whopping $9 trillion in total assets, according to the Investment Company Institute.
That amount is greater than the total annual GDP of Japan, the United Kingdom and France combined. Given the ubiquity of IRA accounts, the odds are good that you may find yourself a beneficiary at some point. Inherited IRAs are governed by a strict set of regulations, and mistakes can be costly in terms of taxes and potential penalties. So it is essential to know the rules.
Let’s start with traditional (non-Roth) IRAs. For spouses, the rules are simple. If your deceased husband or wife named you as the beneficiary, you may simply assume the account as your own. In the event that you have an existing IRA, your spouse’s account can be rolled directly into your own account of the same type. If you don’t have your own IRA account, the inherited account can be retitled and assumed by you with all the tax-deferral characteristics intact. Simple.
It gets more complicated if you are a non-spousal beneficiary. The assets cannot be rolled into your own account, but must be distributed according to one of the following methods.
Basically, you have three choices. First, you may simply claim the dough and pay the taxes. Assuming a traditional (tax-deferred) account, you will declare the proceeds as income on your tax return. This is generally the least favorable outcome, as your distribution will be taxed at the highest marginal rate to which you are subject, and may propel you into a higher bracket.
Assuming you do not wish to distribute the entire amount, you will establish what is called an “inherited” IRA account to receive the proceeds. At that point the clock starts running on the two other options.
The tax code provides that you may fully distribute the balance at any time within five years after the year of death, at any pace you choose. Any distributions are taxable as they occur, but this allows you to reduce the tax bite by spreading it over the five-year period in any combination you prefer. This may be preferable if you anticipate a variable cash flow stream, and wish to distribute more during years of lower income.
Finally, if the account is substantial, you may wish to choose the lifetime distribution option. This choice allows you to compute and receive an amount each year based upon the account value and your life expectancy that theoretically depletes the account by the date of your death. If you do not need the money or are tax-sensitive, this option stretches out the distributions (and the tax burden) over your lifetime. Then tell Uncle Sam to be patient.
Note: spouses may choose the inherited-IRA route instead of rolling it into their own if they wish to begin withdrawals prior to age 59.
Another wrinkle: if the original owner was over 70, a required minimum distribution must be taken each year, including the year of death. You will be responsible for paying the distribution for the current year if it has not yet been satisfied.
If you inherit a Roth IRA, the distribution rules are similar with an important exception: all withdrawals are tax-free, including any earnings the account accrued after inheritance, provided that account was held for at least five years.
Chances are that you may find yourself the beneficiary of such an account one day. Consult your tax professional and be sure to do it right in order to avoid costly errors.
