Inherited IRAs

What are your options?

It's increasingly common for an inheritance to include one or more IRAs, or individual retirement agreements or accounts. IRAs can provide significant investment and tax advantages for heirs, especially when the account holder has named the beneficiaries and coordinated the accounts with other forms of estate planning.

If the original account holder didn't name beneficiaries to the IRA, the assets pass directly into the estate. The treatment of the assets will depend on the owner's age at the time of death, and the heirs have little choice in the matter. If the original owner died before April 1 of the year after turning 70-1/2, the entire amount of the IRA must be distributed by December 31 of the fifth year after his or her death. If the original owner died after this date, the amount must be distributed according to the schedule elected by the owner (either his or her own life expectancy, or a combined life expectancy). If the original owner chose to recalculate his or her life expectancy, the entire amount must be distributed by the end of the year following the year of the original owner's death. Whatever the date of the owner's death, this situation is unlikely to maximize the tax and investment benefits of an inherited IRA.

If you have inherited an IRA as a named beneficiary, you have various options for taking advantage of its benefits. Your best strategy will depend on many factors, including the type of IRA, the age of the original account holder at death, your own age and financial situation, the situation of your beneficiaries, whether you are a spouse of the deceased, and other tax considerations you may have. If you want to take full advantage of an inherited IRA, you should understand the different inheritance scenarios and act accordingly, usually by clearly prescribed deadlines.

Spouse beneficiary. If you have inherited an IRA from your spouse, you are likely to have more options than other types of beneficiaries. Which option is best will depend on the age of your spouse at the time of death, your own age, the type of IRA, and your particular financial situation.

• As a surviving spouse you have the option of rolling over the inherited IRA into your own IRA or otherwise treating it as your own. This would automatically redefine any minimum required distributions (MRDs), as well as the beginning distribution date, according to your life expectancy. If your spouse was over 70-1/2 at the time of death but you are under 70-1/2, this option would allow you to preserve the tax-deferred advantages of a traditional IRA for as long as possible.
• You may transfer the inherited IRA assets to a new Inherited IRA. If you choose this option, the timing of the first MRD will depend on your spouse's age at the time of death, but the amount of the MRDs will be based on your own age and recalculated each year. This option may be better if your spouse was under 70-1/2 but you are over that age, because it allows you to delay the first MRD until your spouse would have reached 70-1/2. Alternatively, if your spouse was over 70-1/2 and you are under 59-1/2, this option allows you to take distributions from the IRA immediately without the 10% early withdrawal penalty.
• The opening of an Inherited IRA and the transfer of funds to the new account must be completed before December 31 of the year following the original owner's death.
• You may disclaim all or part of the inherited IRA assets and allow them to pass onto the next named beneficiary. In this case, the MRD rules would apply to the next beneficiary, wherein the amount of the MRD is based on that beneficiary's age. If you have enough assets from other sources and the next beneficiary is significantly younger than you, this can be a very effective means of preserving and growing assets tax-deferred through another generation. In order to take advantage of this option, you must legally disclaim the inherited IRA assets within nine months of the original owner's death.
• This disclaimer is irrevocable and can have significant tax effects. It's important to consult with a well-informed estate tax attorney before choosing this option.
• You can take the full amount of the IRA in cash. This is generally not the best option, as it forgoes the tax-deferred investment advantages of an IRA and requires you to pay state and federal income taxes on the assets at time of receipt (for a traditional IRA).
• If you have inherited a Roth IRA, your situation is very different because the earnings in a Roth IRA are taxed as they occur, not at the time of distribution. If you are the spouse beneficiary of a Roth IRA you can treat it as your own, which means you have no MRDs and you pay no tax on distributions (assuming the Roth IRA is at least five years old). The 10% penalty on early withdrawals under age 59-1/2 does apply, however.

Non-spouse beneficiary. Non-spouse inheritors of an IRA cannot roll it over into their own, but they still have choices to make and deadlines to meet if they want to preserve the best options available to them.

• You can establish an Inherited IRA and transfer the inherited IRA assets into the new account. As a non-spouse inheritor, the timing of the first MRD is generally December 31 of the year following the original owner's death. However, if you are younger than the original account owner, this option could allow you to invest the assets tax-deferred for significantly longer than you could do by leaving them in the original account, because the amount of the MRDs is based on your own life expectancy.
• If you are one of several beneficiaries of the IRA, make sure you set up your own individual Inherited IRA to receive your share of the assets. If separate accounts aren't set up for each beneficiary, all beneficiaries will have to receive MRDs according to a schedule based on the life expectancy of the oldest beneficiary. This could result in significant erosion of the tax-deferred benefits for you.
• As noted above, you must set up the Inherited IRA by December 31 of the year following the original owner's death. If you fail to do this, you must receive distribution of the entire IRA assets within five years following the year of the owner's death.
• Like a spouse, a non-spouse beneficiary may choose to disclaim part or all of the IRA assets in favor of the next beneficiary. The same advantages mentioned above apply in this case -- significant tax-deferred investments can be preserved into the next generation. Remember, you have nine months after the owner's death to choose this option. Remember, too, such a disclaimer is irrevocable.
• If you have inherited a Roth IRA, the rules applying to you are different than those for spouses. Whereas a spouse inheritor of a Roth IRA has no MRDs but does pay a penalty for withdrawal under the age of 59-1/2, you do not pay any penalty for early withdrawal but you do have MRDs, based on either the five-year rule (assets must be distributed by December 31 of the fifth year after the owner's death) or your own life expectancy, with the first MRD by December 31 of the year following the owner's death.
• Although you do not pay penalties on early withdrawals, you do pay taxes on withdrawals of earnings if the Roth IRA is less than five years old. However, consider that earnings do not include the contributions deposited to the account. If you have inherited a Roth IRA, established three years ago, with contributions of $100,000 and earnings of $30,000, you may withdraw up to $100,000 over the next two years without paying any taxes or penalties. This means it's very unlikely that you would have to pay any taxes on MRDs before the Roth IRA matures at five years. And after this date, all assets distributed from the Roth IRA are tax-free.

Organization or trust. If you represent an organization or trust as the beneficiary of an IRA, the organization must set up an Inherited IRA to receive transfer of the assets. The rules for MRDs from the new IRA are as follows:

• If the inheriting organization isn't a qualified IRS-approved look-through trust, and the original IRA owner was over 70-1/2 at the time of death, the MRD schedule is based on the age of the original owner. If the original owner was under 70-1/2 at the time of death, all assets must be distributed by December 31 of the fifth year after his or her death.
• If the inheriting organization is a qualified IRS-approved look-through trust, MRDs are based on the age of the oldest beneficiary of the trust. In order to qualify for this category, a trust must be valid under state law and irrevocable after the original IRA owner's death, with named beneficiaries and appropriate documentation.

 For more information, please contact Jonathan E. Brochstein at Weston Wealth Strategies—(203) 319-9876 or contact Jonathan via email.

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