Inherited IRAs: Tips You Need to Know

Inherited IRAsRetirement planning is complicated. It’s a personal and situational endeavor with plenty of possible pitfalls in the way of success. Inherited IRA rules vary depending on the beneficiary type: Non-Spouse Beneficiaries, Spouse, and a Trust Beneficiary.

As a beneficiary of an IRA, you may find yourself with many questions and concerns. The rules are different for a non-spouse beneficiary than they are for a spouse or trust beneficiary. Arm yourself with working knowledge of some of the Do’s and Don’ts, and work with a competent, educated financial advisor to keep more of your assets and lose less to taxes and unnecessary fees.

Non-Spouse Beneficiaries

Only move the inherited funds as a direct transfer. Inherited IRA funds must be moved via a trustee-to-trustee transfer; NOT a 60-day rollover. In a direct transfer, the beneficiary does not have use or control of the IRA funds during the transfer.

Make sure the account is properly titled. An inherited IRA must keep the name of the original account owner in the title or clearly indicate that it is an inherited IRA. Example: John Smith, deceased, IRA fbo Jane Jones.

Spouse BeneficiariesDon’t take a full distribution of the inherited IRA. If the non-spouse beneficiary takes a full distribution of the inherited IRA (e.g., a check is made payable to the beneficiary), the entire IRA will be taxable. This is an irreversible error.

Make no contributions to the inherited IRA. Only an account owner can make annual contributions to an IRA. Never make those contributions to your inherited IRA. Doing so causes the IRA to be deemed a taxable distribution to you in the year of the contribution.

Are you a designated beneficiary? The distribution rules are more far more favorable for designated beneficiaries. A designated beneficiary is one who is named on the beneficiary form and has a life expectancy. When you inherit through an estate, the following rules apply. If the IRA owner died before his required beginning date (April 1 of the year after he turned age 70½), then the beneficiary must use the 5-year-rule. If the IRA owner died after the required beginning date, funds must be distributed using the single life expectancy of the deceased account owner.

Make sure you take all RMDs. Any required minimum distribution (RMD) not taken by the IRA owner before her death must go to the beneficiary of the IRA. The RMD for the year of death is calculated as though the IRA owner lived for the entire year. The RMD does not go to the decedent or to the estate, unless the estate is the beneficiary. After the IRA owner dies, the beneficiary must take RMDs. If a beneficiary doesn’t timely take the RMD, there is a 50% penalty on the shortfall. This rule also applies to a Roth IRA beneficiary.

Rules for rolling over inherited funds from an employer plan. Non-spouse designated beneficiaries may do a direct rollover to a properly titled inherited IRA. Both the transfer of the funds and the beneficiary’s first RMD must be done by December 31st of the year after the plan participant’s death in order for the beneficiary to able to use the stretch rules in the IRA. If either of those deadlines is missed, the beneficiary will be forced to use the plan’s rules, even if the funds have been moved to an inherited IRA.

Inherited IRAs can be aggregated – sometimes. You can aggregate IRAs inherited from the same account owner. Example: You inherit two IRAs from your dad held at two different institutions. These accounts can be combined. Example: You inherit an IRA from Dad and an IRA that was Dad’s that had a trust as the beneficiary and you were the beneficiary of the trust. These accounts should not be combined since there were two different beneficiaries – you and the trust.

Spouse Beneficiaries

Spouse beneficiary has different rules! A spouse beneficiary can move an inherited IRA to an IRA in her own name or combine it with an IRA she already owns. The spouse can do a 60-day rollover of the inherited IRA to an IRA in her own name. If the spouse keeps the IRA as an inherited IRA, she has no RMDs until the deceased account owner would have been 70 ½. A spouse beneficiary must use the Single Life Expectancy Table, but goes back to the table each year to get the factor to use in calculating the RMD.

Don’t move the inherited funds too soon. A younger spouse under age 59 ½ who inherits an IRA should consider leaving the IRA as an inherited IRA. As a beneficiary, she can take distributions at any time, in any amount, without being subject to the 10% early distribution penalty. Once the spouse attains age 59½, the inherited IRA should be moved to an IRA in her own name.

Taking a full distribution of the inherited IRA. If a spouse beneficiary takes a full distribution, the spouse could roll over the funds, minus any required minimum distribution for the year, into an IRA in the spouse beneficiary’s own name.

Make no contributions to the inherited IRA. Only an account owner can make annual contributions to an IRA. Never make those contributions to your inherited IRA. Doing so causes the IRA to be deemed your own IRA and you no longer have an inherited IRA.

Are you a designated beneficiary? A designated beneficiary is one that is named on the beneficiary form and has a life expectancy. An estate or charity is never a designated beneficiary. When you inherit through the estate, the following rules apply. If the IRA owner died before his required beginning date (April 1 of the year after he turned age 70 ½), then the beneficiary must use the 5-year-rule. If the IRA owner died after the required beginning date, funds must be distributed using the single life expectancy of the deceased account owner.

Don’t use the wrong life expectancy table. A spouse beneficiary can only use the Single Life Expectancy Table. A spouse beneficiary who makes the inherited IRA her own IRA will use the Uniform Lifetime Table. In either case, the spouse goes back to the table each year to find the correct factor for determining the required minimum distribution for each year.

Why should a spouse roll an inherited IRA over to her own name? Distributions from an inherited IRA will use a factor from the Single Life Table. This factor is larger than the factor an account owner would use from the Uniform Lifetime Table. That means a larger distribution comes out each year which increases the amount of income tax that must be paid. In addition, if the spouse beneficiary dies after the account owner would have been 70½, her beneficiaries do not get to use their own life expectancies but instead must continue to use the spouse’s life expectancy.

Trust As Beneficiary

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There is a trust as the beneficiary of the IRA. There is one beneficiary and it is NOT you. When a trust is named as the beneficiary of the IRA and you are one of the beneficiaries of the trust, you are NOT the IRA beneficiary. You cannot set up an inherited IRA for your benefit and you cannot ask the IRA custodian to make a distribution to you. The trust is the beneficiary, not you. Only the trustee of the trust can make decisions regarding the IRA. There is only one IRA beneficiary – the trust – no matter how many beneficiaries there may be in the trust.

Trust documentation rule. When a trust is the beneficiary of an IRA, the trustee of the trust must give a copy of the trust or a list of the trust beneficiaries and their entitlements to the IRA custodian by October 31st of the year after the account owner’s death. If this is not done, the trust cannot be a see-through trust and the non-designated beneficiary distribution rules will apply.

Only move the inherited funds as a direct transfer. Inherited IRA funds must be moved via a trustee-to-trustee transfer; NOT a 60-day rollover. In a direct transfer, the beneficiary does not have use or control of the IRA funds during the transfer.

Copyright Ed Slott’s Elite IRA Advisor GroupSM