An Individual Retirement Account (IRA) is a valuable asset to inherit. An IRA is a type of savings account that is designed to help individuals save for retirement and offers many tax advantages.
When an individual inherits an IRA, he or she can choose how they want to manage their inheritance. It is important that beneficiaries be mindful of the complex tax laws surrounding inherited IRAs, otherwise, they could end up facing financial consequences.
Questions to Ask About Your Inherited IRA
According to Forbes, when someone inherits an IRA it is important to ask the following questions:
- Did I inherit a Roth IRA or a traditional pre-tax IRA?
- Was the IRA owner over 70 ½?
- Did I inherit the IRA from my spouse?
- Did I inherit an inherited IRA?
These questions can help beneficiaries determine how long they can keep the money in the IRA on either a tax-free (if it’s a Roth IRA) or tax-deferred basis (if it’s a traditional IRA).
Liquidating an Inherited IRA
If an individual inherits an IRA from a non-spouse, they have two options for liquidating the IRA:
- Stretch Option – take distributions over their life expectancy, leaves funds in the IRA as long as possible
- Five-Year Rule – must liquidate the account within five years of the original owner’s death
Beneficiaries who choose the stretch option should have the custodian declare the account as “inherited.” The stretch option allows the funds to be sheltered from taxes, while they continue to grow over time. When an individual chooses the stretch option, he or she must take out the required minimum distribution (RMD) that is based on his or her life expectancy. The amounts in a traditional IRA (including earnings and gains) are taxed only when the funds are distributed. The amounts in a Roth IRA are tax-free, unless the account was established less than five years before. The cutoff date for the first RMD is December 31 of the calendar year following the year that the decedent died. If a beneficiary misses the cut-off date, he or she will be defaulted to the five-year rule.
Under the five-year rule, a beneficiary must take all of the funds out of the IRA within five years. If the account is a Roth IRA, a beneficiary is not forced to pay income taxes on the distribution, as taxes were paid before the money went into the account. If the account is a traditional IRA, the beneficiary will be forced to pay income taxes on the total amount distributed. If the account is substantial, this distribution could drive a beneficiary into a high tax bracket.
Inheriting an IRA from a Spouse
If someone inherits an IRA from their spouse, they have the option of either treating the account as an inherited IRA or rolling over the assets into their own IRA. If the surviving spouse rolls the funds over, he or she will not have to take money out of a traditional IRA until age 70 ½. If the spouse inherits a Roth IRA, no distributions will be required. However, if a spouse makes withdrawals from either type of IRA before age 59 ½, he or she will be subject to early withdrawal penalties.
Inheriting an Inherited IRA
In some cases an individual can inherit an inherited IRA. In this case, the beneficiary will have to take on the role of the original inheritor. If the original inheritor opted for the five-year rule, the current beneficiary must withdraw the contents of the IRA by the end of the original inheritor’s five-year period. If the original inheritor used the stretch option, the current beneficiary must continue the original inheritor’s schedule by using the divisor that applied to him or her in the year they died, and must continue to reduce that divisor by 1.0 for each year after. The individual should advise the custodian to declare themselves as the beneficiary and the original inheritor as the decedent. The person who originally created the IRA will no longer be included on the account.
At Tully Law, PC, we understand that retirement and estate planning can be both emotional and overwhelming. Our attorneys are available to advise you on complex retirement and estate planning issues so as to minimize the possibility of any problems. Our New York estate planning lawyers will take the time to review your goals and circumstances and do our best to ensure that your assets are protected and your wishes will be carried out. For more information regarding our services or to schedule a consultation, contact our New York estate planning lawyers at (631) 424-2800.