If you have inherited an IRA, there are some important rules you must know to avoid some painful and irreversible consequences. The very first step to take is to contact a professional for advice before taking any other action. If you make a move without understanding all implications, you could make an costly mistake. For example, if you tell the custodian who holds the IRA to make a check out for the entire sum of money to you, the estate, or a trust, you just created an unnecessary tax event for yourself, the estate, or the trust, because that entire withdrawal will be deemed income for the current tax year.
A common mistake that people make is assuming that IRA’s which name a trust as the beneficiary means that the entire IRA should now be placed inside the trust. If the entire account balance is withdrawn and placed inside the trust, the IRA is now dissolved, and the entire withdrawal is considered income which is then taxable for the current tax year at the very high trust income tax rates. For example, in 2019, income tax rates for trusts consider only $12,750 of income to be taxable at 37%. A large portion of that IRA has needlessly been taxed at the highest rates. Remember, the Inherited IRA is afforded RMD rules just like other IRA’s. The beneficiary, whether an individual, an estate, or a trust, can withdraw no more than the RMD for each year from the IRA and leave the rest inside the IRA for tax deferral on the money.
It is imperative that the Inherited IRA is retitled properly after death of the account owner. The advice of a financial professional is very important as there can be complex rules involved for Inherited IRA’s.
For example, a properly titled Inherited IRA will include the name of the deceased in the new title of the Inherited IRA, i.e., “John Smith (deceased January 1, 2019) IRA FBO Sally Jones.”
There have been numerous cases where costly mistakes have been made, even by professionals. For example, a lawyer advised a terminally ill owner of an IRA to change the IRA beneficiary from his wife to a newly created IRA trust. After the death of the IRA owner, the lawyer advised the bank to distribute the entire $608,000 IRA to the trust, triggering an income tax rate of 37.9% and over $240,000 in unnecessary income taxes. In addition, the tax deferral of the IRA was lost permanently. Only the RMD had to be paid out to the trust, which was about $24,000 in this example, not the entire IRA balance.
If you have inherited an IRA, ask if any of the contributions to that IRA over the years were non-deductible. How to find out? Look for Form 8606 attached to any of the deceased account owner’s tax returns which reports such non-deductible (after-tax) contributions. If there were such contributions, then as you withdraw from the inherited IRA, some portion of the withdrawal will be considered a return of basis and will therefore not be subject to income tax. Caution: it is rare for professional tax preparers to ask if there were any nondeductible IRA contributions made by the deceased account owner.
If you have inherited a Roth IRA, all the contributions can be withdrawn tax free. The earnings can also be withdrawn tax free if any Roth IRA of the deceased account owner was held for more than five years (including both the time the deceased account owner and the beneficiary hold the Roth IRA). Remember that Inherited Roth IRA’s are still subject to RMD’s, but the RMD’s will generally be income tax free.
If you have inherited an IRA and are the spouse of the deceased, you have two choices. You can roll the entire IRA of the deceased into your own IRA, and the RMD’s will be treated as your own at your age 70 ½, or you can leave the account separate. If you choose to roll it over into your own IRA, and the deceased had an RMD that was not taken in the year of death, that RMD must be taken before the rollover is allowed, or the RMD may be transferred as a trustee-to-trustee transfer to another IRA and then taken later in the year. Caution: if you need access to the money in the account for which you are a beneficiary and you are under 59 ½, you would not want to roll the money into your own IRA, because then the money would be subject to the same rules that apply to your own IRA. For example, if you are age 40 and you did a spousal rollover, the account is now subject to the 59 ½ rule, and any withdrawals would be subject to a 10% penalty. If you are age 40 and you left the money in the deceased spouse’s IRA, you would not be subject to the 10% penalty. You can always choose to roll the money over to your own IRA later.
There are many rules to consider when you inherit an IRA. The best advice I can give you is to seek the advice of a financial professional so that you understand all the rules before making a move that can cost you unnecessarily.