The passing of a loved one creates emotional and financial challenges. The situation becomes more complicated when it is an inherited IRA and you are listed as the beneficiary.
The tax rules on inherited IRAs are complicated, and mistakes can be costly. Try to get a head start on smartly managing your inheritance by following the five steps below.
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The language of retirement accounts can be confusing. Refreshing your knowledge on some basic terms can save you some problems later. You’ll also find it easier to make decisions quickly with minimal additional research. Terms you should know include:
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Traditional IRA: A traditional IRA offers tax-deductible contributions and taxable withdrawals. If you inherit a traditional IRA, you will pay income taxes on withdrawals from the account.
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Roth IRA: A Roth IRA is funded with after-tax money, but qualified withdrawals are tax-free. Your withdrawals from an inherited Roth IRA should also be tax-free if the account has been open for at least five years.
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Beneficiary: If you have inherited an IRA, you are the beneficiary. The original owner of the account previously provided their information to the financial company that manages the account, known as the custodian.
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Required Minimum Distributions (RMDs): RMDs are required withdrawals that apply to traditional IRAs, 401(k), all inherited IRAs, and other types of retirement accounts. Inherited traditional IRA RMDs are taxable. Inherited Roth IRA RMDs are tax-free. If you fail to meet RMDs, unwithdrawn amounts may be subject to taxes of up to 25%.
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Required Start Date (RBD): This is the year the deceased account owner was supposed to start receiving RMDs. RMDs are typically required on traditional IRAs annually beginning in the year the account owner turns 73.
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10 year rule: The 10-year rule requires some beneficiaries to withdraw all funds from the inherited account within 10 years of the deceased account owner’s death. The withdrawal can be a lump sum distribution or spread over time. But if a traditional IRA account owner died on or after the RBD, the beneficiary may also have an annual RMD requirement.
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Life expectancy method: RMDs are based on the life expectancy of an account owner. Some beneficiaries can optionally take RMDs based on their own life expectancy, but this is less common.
More information: Traditional IRA vs. Roth IRA: How to Choose the Right One
Once you know the vocabulary, you’ll be ready to talk to a financial advisor. Tim Witham, founder of Balanced Life Planning, said inherited IRA beneficiaries can easily get into trouble without professional help.
“The most common problems with inheriting an IRA are related to understanding the rules about how much to withdraw, when to withdraw, and the tax implications,” Witham explained.
More information: Withdrawal rules for Roth and traditional IRAs
An experienced financial advisor can explain the options and recommend a safe strategy that suits your financial goals.
For example, you might be tempted to withdraw the funds immediately. But if the account is an inherited traditional IRA, that withdrawal will be taxed as income.
Rachel Richards, head of tax and product manager at tax services provider Gelt, warned that large taxable withdrawals can push you into a higher tax bracket. That could lead to higher taxes and higher Medicare premiums.
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The IRS defines three types of beneficiaries for inherited IRAs and each type has different options for managing the inherited account. The three types are spousal beneficiaries, eligible designated beneficiaries, and named beneficiaries. Let’s review each one and their respective account options.
If your deceased spouse left you the IRA, you can transfer the funds to an IRA in your name or keep the account as an inherited IRA. Transferring the funds to your name is the easiest option. The tax and distribution rules should be the same as any other IRA you own.
If you keep the account separate in your name as an inherited IRA, you can take RMDs based on your life expectancy or the life expectancy of the deceased. Alternatively, you can follow the 10-year rule and accept RMDs in traditional accounts if the deceased died during the RBD or after.
Read more: Retirement Planning: A Step-by-Step Guide
Eligible designated beneficiaries include minor children, disabled or chronically ill individuals, and beneficiaries who are no more than 10 years younger than the deceased account owner.
If you are an eligible beneficiary, you can:
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Take distributions on your life expectancy or the life expectancy of the deceased, whichever is greater.
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Follow the 10 year rule and take RMDs if the deceased died in the RBD or after.
You are a designated beneficiary if you are not in the designated spouse or eligible categories. For example, if you are an adult child of the deceased and do not have any chronic illnesses, you are likely a designated beneficiary.
As a designated beneficiary, you must follow the 10-year rule. “You should ensure that the entire account balance has been withdrawn by the end of the 10th year following the year of the original owner’s death,” said Adam Tolliver, financial advisor and partner at Artisan Financial Strategies. “This is the most common scenario that non-spousal beneficiaries of an IRA find themselves in,” Tolliver explained.
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The IRS does not prohibit you from withdrawing inherited funds immediately, but doing so can be costly. You will pay taxes on traditional withdrawals from inherited IRAs. You’ll also give up years of tax-deferred growth on traditional and inherited Roth IRA account balances.
For example, if you follow the 10-year rule, you will have a decade of tax deferrals available for funds not subject to RMDs. The financial impact of those deferrals can be powerful.
Suppose you inherit $100,000 in a Roth IRA, invested to earn an average annual return of 7%. Leave the funds in the tax-advantaged account and they should grow to approximately $195,000 in 10 years. Move the funds to a taxable account with the same yield and your after-tax balance after 10 years will be about $25,000 less, assuming a 22% marginal tax rate.
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Vincent Birardi, a wealth advisor at Halbert Hargrove, recommended immediately naming the beneficiaries of your inherited IRA. “Those beneficiaries can take over your inherited IRA when you die. This applies even if you inherited an IRA from someone other than your spouse and you die before the 10-year full liquidation period,” Birardi explained.
The process for naming IRA beneficiaries should be simple. Contact your IRA custodian for details.
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Choosing the right path to take with an inherited IRA is complicated. You must juggle your financial needs and IRS rules while grieving the loss of a loved one. Understanding IRS distribution requirements and consulting with an experienced financial advisor can help you formulate a plan that makes sense for you.
Tim Manni Edited this article.