What Beneficiaries Should Know About Taxation of Inherited IRAs

Whether you are the lucky beneficiary or the owner of the original IRA, if you don’t understand the IRA inheritance rules you may be subjecting the account to higher taxes or lower growth, even penalties. It is imperative to pay attention to the tax-efficient aspects of IRA planning and get educated about the opportunities to preserve retirement savings post mortem.

A beneficiary can be a person or an entity. Whether you are a spouse or a non-spouse greatly impacts what you can do with the inherited IRA and how the IRS views distributions. Beneficiaries of retirement accounts or traditional IRAs must include in their gross income any taxable distributions they receive.

Is The Beneficiary A Spouse?

If you inherit a traditional IRA from your spouse, the funds in the account are treated as yours, and distribution rules are the same as if the account had always been yours. Spouses have the option to base their Required Minimum Distributions or RMDs on the original owner's life expectancy which makes sense if it reduces the amount you're required to take out because the balance in the account earns interest. You may also transfer the inherited assets directly into your own personal retirement accounts. A surviving spouse generally has these choices:

• Treat it as your own IRA by designating yourself the account owner.
• Transfer the funds to your existing retirement savings. Roll it over into a traditional IRA, or qualified employer plan, qualified employee annuity plan, or tax-sheltered annuity plan.
• Treat yourself as the beneficiary rather than treating the IRA as your own.
• “Disclaim” (decline to inherit) all or part of the assets so they will pass to the other eligible beneficiaries.
 

If you receive a distribution from your deceased spouse's IRA, it can be rolled over into your IRA within a 60-day time limit, as long as the distribution is not a required distribution, even if you are not the sole beneficiary your deceased spouse's IRA. Any distributions transferred to a new account in your name within 60 days won't be taxed, and the money can continue to grow tax-deferred in your account.

Keep in mind if you're under 59 1/2 years of age and you transfer the money into your retirement account, you won't be able to touch it until you reach 59 1/2 unless you pay a 10% early-withdrawal penalty on top of income taxes, assuming it's a traditional IRA as opposed to a Roth IRA.

If you plan to use the money now, you may wish to remain a named beneficiary, which enables you to take penalty-free withdrawals, even though you still have to pay income tax if it's a traditional IRA.

Is The Beneficiary A Non-Spouse?

Should you inherit an IRA or employee-sponsored retirement plan from a parent, sibling, another relative, or friend, the rules are strict. You cannot treat it as your own, cannot make any contributions to it, nor can you roll over any amounts into the IRA or out of the IRA into your own retirement account. You'll be required to take annual minimum distributions by December 31st of the year following the original owner's death. You can always take out more than the required minimum distribution (RMD), but if you fail to take out at least that amount, you'll be hit with a 50% penalty on the amount that was not withdrawn on time.

When it comes to how you want to take the distributions, these are your options:

• Cash in the IRA now and take a lump-sum payment. When taking the money from an inherited traditional IRA, you won't be charged a 10% early withdrawal penalty, even if you're under age 59 1/2, but you will have to pay taxes on the money. Cashing in a large IRA could mean that a large percentage will go to pay federal taxes and state income taxes.
• Cash in the IRA within a five-year distribution period. There won't be RMDs, no penalty tax applies, but all the money will need to be withdrawn from the inherited IRA by December 31st of the 5th year following the original IRA owner’s death.

What else can you do? Stretch! To take withdrawals out slowly you can open a new Inherited IRA or a Beneficiary IRA account and transfer the funds into this account. Beneficiaries can’t make additional contributions, but the funds can continue to grow tax-deferred, and you can generally withdraw money right away without a penalty. Regardless of YOUR age, you must take Required Minimum Distributions (RMDs) annually from an Inherited IRA based on the age of the original account holder. The amount will be based on your own life expectancy and the account value. If you only take out the RMD amount each year, you can continue to grow the Inherited IRA and eventually pass it down to your own heirs. In addition, please note:

• Choosing the “Stretch IRA” option of taking withdrawals over your life expectancy does not mean you can’t withdraw the money faster if you need it – you can.
• With an Inherited Traditional IRA, you’ll pay taxes on any distributions you take. Generally, your distribution is included in your gross income and will be subject to ordinary state and federal income taxes.
• If you opt to take a full distribution it will be considered taxable income and may push you into a higher tax bracket.
• Consider a trustee-to-trustee transfer. Move money into an IRA that is set up in the name of the deceased IRA owner strictly for the beneficiary, making sure that any assets transfer directly from one account to another or from one IRA custodian to another. Beneficiaries will not owe tax on the assets in the IRA until they receive distributions. If you receive a check, the money will generally be taxed as ordinary income, and is ineligible to be deposited into an inherited IRA you may own elsewhere.
• Be sure the IRA custodian registers the new account properly. The account registration should include the name of the person inherited from, that the account is an IRA beneficiary distribution account, and the inheritor's name. And once the IRA is retitled, don't forget to name successor beneficiaries.
• With an Inherited Roth IRA, you don’t pay taxes on distributions.

Is The Beneficiary An Entity?

If a trust or other entity inherited the IRA a different set of rules apply.

Consider transferring the portion you intend to leave to a charity into a separate IRA account. If other beneficiaries inherit the same IRA as a charity and the charity’s portion is not “cashed out” or split within the IRS prescribed time frames, the stretch IRA for the living beneficiaries will be lost.

A charity is a “non-designated beneficiary,” because it has no life expectancy. A look-through trust allows for post-death distributions to be stretched based on the trust beneficiary with the shortest remaining life expectancy. Since a charity has no life expectancy, if it is named as a beneficiary of a trust that is also inheriting an IRA, it can eliminate the stretch for the remaining trust beneficiaries.

In general, trusts are also non-designated beneficiaries. When a trust is named beneficiary, then minimum distributions are required to be made from the IRA to the trust. Bypassing the trust is not allowed. Distributions are then made to the trust beneficiaries, following the rules set forth in the trust. The trust can cash in the IRA and it is likely it will have to do so within five years. The exception to this would be if all beneficiaries of the trust are individual people, then there may be the option of stretching distributions out over the life expectancy of the oldest trust beneficiary.

What If There Are Multiple Beneficiaries?

In the case of multiple beneficiaries on an account, each one must open an individual inherited IRA account to transfer the funds into. RMDs are then calculated according to each beneficiary's age. If the IRA assets aren't separated by the December 31st deadline, the RMDs are determined by the oldest beneficiary's age until the funds are separated.

Special Notes:

• When funds are distributed from an inherited account, the money is your own. Distributions from an inherited IRA can be invested in other accounts.
• If you inherit IRAs from different owners, you cannot combine them into a single inherited IRA. If they were inherited from the same original owner, it is allowed.
• Non-spouse beneficiaries do not have bankruptcy protection with inherited IRAs.
• Roth IRA owners never have to take RMDs, but non-spouse beneficiaries must. However, withdrawals from an inherited Roth IRA are still tax free.
• IRAs with multiple beneficiaries that include a charity or other non-person entity must pay out that entity's share by September 30 of the year following the owner's death. If a trust is a beneficiary, send a copy of the trust to the IRA custodian by October 31 of the year following the year the owner died.
• IRA beneficiary designations supersede a will, do not forget to review your plans when there are major life changes.

Rules for Roth IRAs

The rules are much the same with a few exceptions:

• If a Roth IRA is left to your spouse, they can treat it as their own. They won’t be required to take distributions or have to pay taxes.
• If you name a non-spouse as a beneficiary, when they establish an inherited Roth IRA, they will have to choose whether to use the life expectancy method or the five-year method.
• Non-spouse beneficiaries will need to withdraw a minimum amount each year. The benefit of the Roth IRA is that your beneficiaries don’t pay income tax on the distributions (as long as you held the account for more than five years).
• Roth IRA beneficiaries have the same “stretch” payout over their lifetime opportunity as those inheriting a traditional IRA. Beneficiaries can control the amount of distributions and the time over which they take them, which is a significant tax benefit. The entire account plus any future earnings are distributed tax free regardless of the investment.

CONTACT US: The rules reviewed in this article are just the tip of the iceberg! If you're not careful with an inherited IRA you may end up paying more in taxes than you should, especially if the IRA is sizable. When a loved one passes, their old retirement accounts may be the last thing on your mind. But beneficiaries must understand the rules to avoid decisions that could cost taxes and penalties. Dealing with an estate can be tricky enough but even more complicated when an IRA or other qualified retirement plan is involved. Check with your attorney, but also with a qualified Fuoco Group tax professional so you administer an estate tax –efficiently and in compliance with the Tax Code. Contact us toll free at 855-534-2727.
 

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