When my father in-law, Howie, passed away earlier this year, the last thing we were thinking about was the inheritance. Funeral and burial arrangements had to be made, obituaries written, and fond memories needed to be shared over a couple glasses of wine. Once the initial shock of his passing wore off, we were faced with dealing with Howie’s legacy. He had named his four children as the beneficiary of his IRA. I have worked with many clients that have inherited IRAs, but it is different when dealing with your own family. Still, I knew that if the family didn’t handle the inheritance of the IRA correctly, the family could face some significant tax consequences. This article is meant to help your family deal with the very difficult subject of inheriting an IRA.
Beneficiary is not a spouse or multiple beneficiaries are named
If you are not the spouse of the decedent or if the spouse in not the only beneficiary of the IRA, the beneficiary will need to open an inherited IRA. An inherited IRA is an IRA in the name of the new beneficiary but unlike your own IRA, distributions need to start immediately. There are two distribution options for an inherited IRA. One, stretch out yearly distributions based on your age and life expectancy, starting the year after the account holder has passed. Or, distribute the full account within 5 years of the account holders death. If the decedent had already started collecting his Required Minimum Distributions (RMD), then the 5-year distribution rule is not allowed and the beneficiary will need to stretch distributions over her life. A person begins collecting RMDs, when they turn age 70 ½.
One of the biggest mistakes that I see with inherited IRAs, is the failure to do anything. For example, the other day a new client came in to my office, and showed me his inherited IRA that he received when his father passed away 5-years ago. As mentioned earlier, if distributions aren’t started the year after the decedent’s death, then the full account needs to be distributed within 5-years. Unfortunately, because my client hadn’t started distributions, now he has to take the full distribution this year. Instead of taking yearly distributions and spreading the tax liability over his life, he had to take the full distribution now and pay a huge tax bill in the process.
Almost always it is the best interest of the beneficiary to stretch the distributions over her life. This allows him to take smaller amounts each year which helps lower the tax bill and helps the assets grow. Of course, if he needs more money than the required amount each year, he can take as much as he needs. There has only been one situation in which the 5-year distribution rule made sense for a client of mine. She was within three years from retiring when her father passed, and she was named beneficiary of his IRA. When she retired her income was going to go way down, but she needed some money to purchase a new home. We utilized the 5-year distribution rule so that we could avoid taking distributions while she was still working and at a higher tax bracket. We then took a full distribution in retirement, four years after her father passed away, and used the proceeds for the new home. Unfortunately, usually I see a person utilize the 5-year rule when they mistakenly forgot to take distributions and are essentially forced to take a complete distribution.
The spouse is the only beneficiary
If you are the spouse of the deceased and are the only beneficiary listed on the account, you have an additional option. In this case, you can roll the funds into an inherited IRA, as discussed above, or roll the funds into your own IRA. Rolling the funds into your own IRA allows you to defer distributions until you are age 70 ½. This can allow you to continue to grow the account and you have more freedom how you take distributions. Typically, I will suggest a surviving spouse roll the decedent’s IRA into their own IRA and follow the normal Required Minimum Distribution (RMD) rules. This allows additional flexibility in taking distributions and you aren’t forced to start distributions (assuming you are under 70 ½) if you don’t need the money yet.
There is one specific circumstance though in which it makes sense for the remaining spouse to use an inherited IRA instead of rolling into their own IRA. If the surviving spouse is under age 59 ½ and needs the income from the IRA immediately, it typically makes sense to transfer the IRA to an inherited IRA. A person needs to be over age 59 ½ to take penalty free withdrawals from their own IRA. Instead, the spouse can transfer the funds into an inherited IRA and can start taking penalty free withdrawals immediately.
I understand that dealing with a loved ones IRA is probably one of the last things that you are worried about after they pass away. Still, dealing with the estate of a loved one sooner rather than later, will ultimately give you more options. Typically, if it is your spouse who passed away, you will want to roll the IRA into your own IRA, which allows you to postpone your distributions until you reach age 70 ½. If you are not the spouse of the deceased, typically you will want to transfer the IRA into an inherited IRA and spread the distributions out throughout your lifetime. Still, you will want to analyze your situation before making any decision, and the wrong decision unfortunately, can result in a large unwanted tax bill. My wife and I have decided to use her father’s inheritance to take a yearly vacation to visit the rest of her family. By transferring the funds into an inherited IRA, we can focus on honoring him, without losing his legacy to taxes.