7 Steps to Take When You Inherit an IRA - Rodgers & Associates
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7 Steps to Take When You Inherit an IRA

An IRA can be a wonderful account to inherit. However, the rules are complex and errors can be costly. There are some great tax advan­tages if you handle the inher­i­tance correctly. Unfor­tu­nately, there can poten­tially be a big tax bill if you don’t. Follow these steps to avoid a few common mistakes and maximize the benefits of your new inher­i­tance.

1.  Designated beneficiary or inherited through the will

Being named as the benefi­ciary of the IRA allows the heir to stretch distri­b­u­tions over his or her lifetime. An heir who is named on the IRA account is called a desig­nated benefi­ciary. This type of benefi­ciary can use life expectancy at the age he or she will be at the end of the year following the death of the IRA owner. Each succeeding year they subtract one from the prior year’s factor to determine the amount of the distri­b­ution for the current year.

An heir who inherits an IRA through an estate or will is known as a non-designated benefi­ciary. The age of the original IRA owner at the time of death deter­mines the distri­b­ution options for non-designated benefi­ciaries.

  • If the original IRA owner has not reached the date of their first required distri­b­ution after age 70½, the heir must empty the account using the 5‑year rule. All funds must be distributed to the benefi­ciary by the end of the fifth year after death.
  • If the original owner dies after starting post 70 ½ distri­b­u­tions, the heir can take minimum distri­b­u­tions based on the deceased owner’s age at the time of death. The payout period using this method could be as long is 15.3 years (based on life expectancy of someone who died at age 71). The older the IRA owner, the shorter the distri­b­ution period available to the non-designated benefi­ciary.

2. Sole beneficiary or is the IRA shared with others

It is not unusual to name more than one person as the benefi­ciary of an IRA. Each benefi­ciary can use their life expectancy provided the IRA is split into individual accounts. There is a deadline for splitting the IRA. Keep these two dates in mind:

  • September 30th of the year after the account owner’s death — desig­nated benefi­ciaries must be deter­mined.
  • December 31st of the year after the account owner’s death – the split of the inherited IRA must be completed.

Some benefi­ciaries may not want to stretch distri­b­u­tions and instead would cash out.  Benefi­ciaries who are entities (such as charities) should also be distributed during this period. Remaining desig­nated benefi­ciaries must split the IRA before the deadline to stretch distri­b­u­tions over their life expectancy. The IRA can still be split if the deadline is missed but all the benefi­ciaries must use the shortest life expectancy (the oldest benefi­ciary) to calculate minimum distri­b­u­tions.

3. Title the new IRA correctly

Setting up the inherited IRA correctly is an important step and must be done properly to stretch distri­b­u­tions. Inherited IRAs must contain the name of the original IRA owner (the deceased) and indicate the IRA is inherited. For example – John Doe Jr. Benefi­ciary IRA, John Doe Sr. deceased 6/1/2017. Only a spouse of the deceased can rollover an inherited IRA into their name. Otherwise, an inherited IRA must always be kept as a separate account.

4. Name your beneficiary

Part of the process of setting up an inherited IRA should include naming your benefi­ciary for the account. If an heir taking stretch distri­b­u­tions dies before emptying the inherited IRA account, their benefi­ciary will be able to continue taking distri­b­u­tions based on the first heir’s life expectancy.

5. Calculate the correct distribution amount

Two pieces of infor­mation will be needed: The prior year-end account value and life expectancy.

  • Year-end value – To determine a minimum distri­b­ution, use the account value as of the end of the prior year. Distri­b­u­tions for 2017 will use account values as of December 31, 2016. The first distri­b­ution is required from an inherited IRA by December 31st of the year following the year of death. The account may not have been split at the prior year-end. In that situation, the account value is divided by the percentage the heir has inherited.
  • Life expectancy – The table used for non-spouse benefi­ciaries is the Single Life Expectancy Table found in IRS Publi­cation 590‑B. The heir will find their age in the year after the IRA owner’s death. This only needs to be done once. Each year after that the heir will subtract one from the prior year’s factor.

Even if the inherited IRA is a Roth IRA, benefi­ciaries are required to take minimum distri­b­u­tions. All the same rules apply as noted previ­ously. The exception being when the Roth benefi­ciary is a non-designated benefi­ciary. Roth IRA owners are not required to take minimum distri­b­u­tions at age 70 ½. The only distri­b­ution option for a non-designated benefi­ciary is the 5‑year rule.

6. Determine any after-tax basis in the IRA

The after-tax basis is often overlooked in an inherited IRA. Benefi­ciaries of IRAs with after-tax contri­bu­tions need to file Form 8606 to claim the non-deductible portion of their required minimum distri­b­ution. Many benefi­ciaries never bother to determine if the IRA they inherited has an after-tax basis. The executor may not know unless they go back through tax returns of the deceased to determine if Form 8606 had been filed in earlier years. IRA benefi­ciaries should ask about after-tax contri­bu­tions and research prior year tax returns if necessary.

7. Plan for the taxation of distributions

Roth IRAs – A five-year period began with the original Roth IRA owner’s first Roth conversion or contri­bution. Part of the heir’s distri­b­ution attributed to earnings could be taxable if the five-year period for qualified distri­b­u­tions was not satisfied. Fortu­nately, the IRS ordering rules say earnings come out last and the five-year period does not start over for the benefi­ciary. Roth IRA distri­b­u­tions would likely all be tax-free for a benefi­ciary taking minimum distri­b­u­tions.

All other IRAs — Distri­b­u­tions from a tradi­tional IRA, SEP IRA, and SIMPLE IRA will be fully taxable unless the IRA owner had a tax basis in their IRA. Step six explained how to determine whether there is any tax basis. Step five explained how to calculate the amount of the distri­b­ution. Add the taxable portion of the distri­b­ution to a tax projection for the year to determine how much tax to withhold.

Note the 10% early withdrawal penalty for those under age 59 ½ never applies to distri­b­u­tions from inherited tradi­tional or Roth IRAs. Distri­b­u­tions due to death is one of 10 penalty exemp­tions for early distri­b­u­tions.

Talk to a knowl­edgeable adviser if you receive notice you will be inher­iting an IRA.  Preferably an experi­enced retirement adviser. Making a mistake could mean the loss of the ability to take stretch payments or worse — a large tax bill on your inher­i­tance.

Rick’s Tips:

  • Desig­nated benefi­ciaries can stretch payments over life expectancy. Non-designated benefi­ciaries must use the 5‑year rule.
  • Multiple IRA benefi­ciaries must split the IRA to take distri­b­u­tions based on each beneficiary’s life expectancy.
  • Even Roth IRA benefi­ciaries are required to take annual minimum distri­b­u­tions.