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News and Articles from the Law Offices of John C. Martin

What to Do with an Inherited IRA

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IRAs are among the largest assets inherited by heirs and
beneficiaries. These accounts have been able to grow to such large amounts
because income taxes are deferred until the owner begins to take distributions,
usually after reaching age 70 ½.

 

Those who inherit an IRA must be
very careful to follow the rules, which are complicated and often confusing. It
is possible to keep an account growing tax-deferred for decades, but an
innocent error can cause the recipient to lose the tax-deferred advantage and force
her to pay tax now on the entire account balance. As a result, it is critical
to talk with an expert before making any decision or taking any action, and to
understand all available options. Here are some to consider.

 

Cash Out Option

Anyone who inherits an IRA can cash it out and withdraw the
full amount. But because income taxes must be paid on the full amount at one
time, this is not usually the best choice.

 

Spouse Options

A surviving spouse who inherits an IRA from his/her spouse
can roll it into a new IRA or merge it with his/her own IRA. In either case,
the account can continue to grow tax-deferred and the surviving spouse can
continue to make contributions until he/she must start taking required
distributions (after age 70 ½).

 

If it is rolled into a new IRA, the surviving spouse will
name new beneficiaries. It is highly advantageous to name someone who is much
younger (e.g., children and/or grandchildren) because after the surviving
spouse’s death, distributions will be based on the beneficiary’s actual life
expectancy. This will allow the account to continue to grow tax-deferred for
decades. Under IRS rules, this rollover and stretch out can be done even if the
original owner spouse had started taking required minimum distributions before
he/she died.

 

Non-Spouse Options

If the original owner died before beginning to receive required distributions, a non-spouse
beneficiary can establish a Beneficiary IRA and start taking annual
distributions based on his/her own life expectancy, with the option to take a
lump sum at any time. (This is called the “life expectancy option.”) This must
be done by the end of the year following the original owner’s death. If the
first distribution is not taken by then, all of the IRA must be withdrawn by
December 31 of the fifth year after the owner’s death. (This is called the
“five year rule.”)

 

If the original owner died after beginning to receive required distributions, a non-spouse
beneficiary must take a distribution equal to the owner’s required minimum
distribution for the year he/she died if one had not been taken. For subsequent
years, distributions can be based on either the new owner’s life expectancy or
the original owner’s remaining life expectancy (whichever is longer).

 

The original owner’s name must be listed on the title, but
the inheriting beneficiary will name new beneficiary(ies). A non-spouse
beneficiary cannot roll an inherited IRA into his/her own IRA or make
contributions to an inherited IRA, as a spouse can. But when distributions are
stretched out over a longer period of time, the tax payments are also stretched
out. And by keeping more money in the IRA for as long as possible, the
tax-deferred growth can be maximized…which will result in a much larger
balance.

If you have questions, contact our Redwood City Estate Planning Attorneys, serving all of the Bay Area. 

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