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.
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.
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 If the first distribution is not taken by then, all of the IRA must be withdrawn by December 31 of the fifth year after the owner’s death.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.
Thinga to Consider:
- cashing out an IRA is generally always going to be the wrong choice because of the potential for disastrous tax consequences – consider not leaving this choice up to your heirs (who are likely to cash it out); rather, consider the continued tax deffered growth potential if that IRA is held in trust for your beneficiaries
- spouses can roll over IRAs, but have the ability to name new beneficiaries when they do – in a second marriage situation, this could accidentally disinherit children from the first marraige if the surviving spouse rolls the account over and names new beneficiaries
- Using a stand alone IRA trust for large IRAs can give your beneficiaries use and enjoyment of those funds while adding asset protection and retaining the tax deffered growth within such plans
For more on IRAs a beneficiaries of Trusts and Standalone IRA Trusts, See the previous post on Naming a Trust as Beneficiary of an IRA, andDiscretionary Trusts – How to Protect Your Beneficiaries from Bad Decisions.