Inheriting an IRA

If you inherit an individual retirement account (IRA) then you may be facing decisions about what to do with this asset.

Inheriting and IRA requires work in the areas of estate planning, financial planning, and tax planning which makes the account a difficult one to handle. You will want to be wise when determining the future of an IRA because the sad truth is that one small mistake could lead to a very expensive chain reaction of consequences.

Most attorneys say that an heir of an IRA account should not do anything with the asset until he or she has consulted with a financial adviser. One financial professional says that the worst thing that someone can do with their inherited IRA is to cash out the plan and put it in their account. This can lead to expensive taxes and other costly fees that could have been avoided with a little more careful planning.

When you have an inherited IRA, you will have to take the money out of the account eventually unless you are the spouse of the decedent. Non-spouse beneficiaries typically can liquidate their account using two methods.

One method is to take distributions over their life expectancy. This is known as the stretch option or the “inherited IRA Option” and leaves the funds in the IRA for as long as possible. The account holder is only required to withdraw a percentage each year based on his or her life expectancy. (30 year life expectancy = 1/30th with drawl each year)

If you don't choose a stretch plan or fail to make one correctly, then you will need to liquidate the account within five years of the previous owner's death. This is called the five-year rule.

If you are the spouse of the decedent and inherited his or her IRA, then you can take it and treat it exactly as if it were your own.

If you are a non-spouse beneficiary and received an IRA, then you will want to get moving concerning the account as soon as possible. If you decide that you want to stretch the IRA, then you will want to take a yearly required minimum distribution, based on your own life expectancy.

There is typically a cutoff date for the first RMD as well. You will typically need to take your first distribution from the account in the next calendar year by December 31st of the calendar year after the decedent died. If you miss that date, then you will need to default to the five-year plan.

When you are making decisions regarding your IRA you will want to be aware of any year-of-death RMDs. The best idea is to figure out if the benefactor took the required minimum distribution for the year that he or she died. If the decedent did not take out this minimum distribution, then you need to do this for him or her or you may be liable for a 50% penalty of the required distribution.

If a person dies late in the year, it can be very difficult to get the distribution taken care of before December 31st, so you may need a professional there to help you. Thankfully, there is not year-of-death required distribution for a Roth IRA or if the deceased was not yet 70 ½ years old.

If you inherit an IRA, then you will get an income tax deduction for the estate taxes paid on the account. The taxable income that is earned is called income in respect of a decedent. Whenever you have to take a distribution from an IRA, it will typically be considered taxable income. If your benefactor's estate had to pay a federal estate tax, then you will be eligible for an income tax deduction for the estate taxes that were paid on the IRA. You don't have to be the person that paid the estate taxes. As long as the IRS receives the money, you will be eligible for a deduction.