by Laura Johnson, EA
So, your favorite Aunt Martha left you her IRA. Now what?
Dealing with an inherited IRA is probably the last thing on your mind as you mourn your loss, but if you can set aside some time and mental energy to deal with it now, you will avoid some potentially costly mistakes.
Find out some basic details:
- Is it a traditional IRA or a Roth IRA?
- Are you the sole beneficiary of the IRA? Or are there other parties?
- Who are they?
- How old was the decedent when he/she passed away?
- Had the decedent been taking distributions from the plan prior to his/her death? Did he/she take a distribution in the year of death?
What you do next will depend on what you find out.
The most common fact pattern we see in our firm is that of a loved one who died after the age of 70½, while they were receiving annual distributions from their IRA. If you were the sole beneficiary, in a case like this, and the decedent had not taken a distribution for the year of his or her death, then you, the beneficiary, must do so in the year of death. If the decedent had taken a distribution prior to death, then you must continue making withdrawals, starting in the year following death.
How much must you take out each year from the plan?
If you are the sole beneficiary, and NOT the spouse of the decedent, you have to take a required minimum distribution (RMD) based on the value of the plan assets and your life expectancy. If you are the surviving spouse, you can elect to treat the IRA as your own, adding it to your personal IRA account if you like, and determining any required withdrawals as if the inherited money had always been yours.
- If there are multiple beneficiaries, all of them must take distributions based on the life expectancy of the eldest beneficiary.
- If a trust is the beneficiary, the entire balance must be paid out within five years after the year of death, unless the trust qualifies as a “see-through” trust. Where trusts or estates are beneficiaries, seek professional advice to make sure you follow the proper rules.
Roth IRAs are great to inherit, because no tax applies when you take money out, so long as at least five years have elapsed since the decedent first funded a Roth account. You cannot leave money in an inherited Roth account forever. You can either take the entire balance within five years of the year of the decedent’s death, or spread the withdrawals over your life expectancy.
What if you want to take out more than the minimum?
Our discussion focuses on the minimum amount. Generally, it is most tax-efficient to take out as little as possible, to keep the remaining assets growing tax-free within the plan. But perhaps you would like to use the money to fund a home renovation or pay off some other debt.
You can always take out more than the minimum required, though funds taken from a traditional IRA will generally be taxable. Be sure to consult your tax professional to help estimate the tax effect of the distribution. The tax hit can be a surprise if you aren’t ready for it.
Who can help me?
Consult your tax professional to estimate the tax effect of an IRA distribution, and for help calculating and planning for any required withdrawals.
What if I messed up?
It is not unusual for beneficiaries of inherited IRAs to make mistakes administering the IRA, especially in the first year or two. Technically, hefty penalties apply. However, the IRS is frequently generous with waiving those sanctions; the instructions on the form explicitly state how to request abatement of penalties.
A final consideration
If you have inherited an IRA, consider changing the allocation of assets inside the account. The decedent may have invested in assets suitable for his or her time of life. But that may not be the best asset allocation for a younger beneficiary. You should talk to your financial advisor about choosing the appropriate asset allocation for your needs.
At John Schachter + Associates, we help our clients make the most of inherited traditional and Roth IRAs. Let us know if we can help you.