Rick Rodgers, CFP®, CRPC®
Certified Retirement Counselor®

An IRA can be a wonderful account to inherit. However, the rules are complex and errors can be costly. There are some great tax advantages if you handle the inheritance correctly. Unfortunately, there can potentially be a big tax bill if you don’t. Follow these steps to avoid a few common mistakes and maximize the benefits of your new inheritance.

1.  Designated beneficiary or inherited through the will

Being named as the beneficiary of the IRA allows the heir to stretch distributions over his or her lifetime. An heir who is named on the IRA account is called a designated beneficiary. This type of beneficiary can use life expectancy at the age he or she will be at the end of the year following the death of the IRA owner. Each succeeding year they subtract one from the prior year’s factor to determine the amount of the distribution for the current year.

An heir who inherits an IRA through an estate or will is known as a non-designated beneficiary. The age of the original IRA owner at the time of death determines the distribution options for non-designated beneficiaries.

  • If the original IRA owner has not reached the date of their first required distribution after age 70½, the heir must empty the account using the 5-year rule. All funds must be distributed to the beneficiary by the end of the fifth year after death.
  • If the original owner dies after starting post 70 ½ distributions, the heir can take minimum distributions based on the deceased owner’s age at the time of death. The payout period using this method could be as long is 15.3 years (based on life expectancy of someone who died at age 71). The older the IRA owner, the shorter the distribution period available to the non-designated beneficiary.

2. Sole beneficiary or is the IRA shared with others

It is not unusual to name more than one person as the beneficiary of an IRA. Each beneficiary can use their life expectancy provided the IRA is split into individual accounts. There is a deadline for splitting the IRA. Keep these two dates in mind:

  • September 30th of the year after the account owner’s death – designated beneficiaries must be determined.
  • December 31st of the year after the account owner’s death – the split of the inherited IRA must be completed.

Some beneficiaries may not want to stretch distributions and instead would cash out.  Beneficiaries who are entities (such as charities) should also be distributed during this period. Remaining designated beneficiaries must split the IRA before the deadline to stretch distributions over their life expectancy. The IRA can still be split if the deadline is missed but all the beneficiaries must use the shortest life expectancy (the oldest beneficiary) to calculate minimum distributions.

3. Title the new IRA correctly

Setting up the inherited IRA correctly is an important step and must be done properly to stretch distributions. Inherited IRAs must contain the name of the original IRA owner (the deceased) and indicate the IRA is inherited. For example – John Doe Jr. Beneficiary IRA, John Doe Sr. deceased 6/1/2017. Only a spouse of the deceased can rollover an inherited IRA into their name. Otherwise, an inherited IRA must always be kept as a separate account.

4. Name your beneficiary

Part of the process of setting up an inherited IRA should include naming your beneficiary for the account. If an heir taking stretch distributions dies before emptying the inherited IRA account, their beneficiary will be able to continue taking distributions based on the first heir’s life expectancy.

5. Calculate the correct distribution amount

Two pieces of information will be needed: The prior year-end account value and life expectancy.

  • Year-end value – To determine a minimum distribution, use the account value as of the end of the prior year. Distributions for 2017 will use account values as of December 31, 2016. The first distribution is required from an inherited IRA by December 31st of the year following the year of death. The account may not have been split at the prior year-end. In that situation, the account value is divided by the percentage the heir has inherited.
  • Life expectancy – The table used for non-spouse beneficiaries is the Single Life Expectancy Table found in IRS Publication 590-B. The heir will find their age in the year after the IRA owner’s death. This only needs to be done once. Each year after that the heir will subtract one from the prior year’s factor.

Even if the inherited IRA is a Roth IRA, beneficiaries are required to take minimum distributions. All the same rules apply as noted previously. The exception being when the Roth beneficiary is a non-designated beneficiary. Roth IRA owners are not required to take minimum distributions at age 70 ½. The only distribution option for a non-designated beneficiary is the 5-year rule.

6. Determine any after-tax basis in the IRA

The after-tax basis is often overlooked in an inherited IRA. Beneficiaries of IRAs with after-tax contributions need to file Form 8606 to claim the non-deductible portion of their required minimum distribution. Many beneficiaries never bother to determine if the IRA they inherited has an after-tax basis. The executor may not know unless they go back through tax returns of the deceased to determine if Form 8606 had been filed in earlier years. IRA beneficiaries should ask about after-tax contributions and research prior year tax returns if necessary.

7. Plan for the taxation of distributions

Roth IRAs – A five-year period began with the original Roth IRA owner’s first Roth conversion or contribution. Part of the heir’s distribution attributed to earnings could be taxable if the five-year period for qualified distributions was not satisfied. Fortunately, the IRS ordering rules say earnings come out last and the five-year period does not start over for the beneficiary. Roth IRA distributions would likely all be tax-free for a beneficiary taking minimum distributions.

All other IRAs – Distributions from a traditional IRA, SEP IRA, and SIMPLE IRA will be fully taxable unless the IRA owner had a tax basis in their IRA. Step six explained how to determine whether there is any tax basis. Step five explained how to calculate the amount of the distribution. Add the taxable portion of the distribution to a tax projection for the year to determine how much tax to withhold.

Note the 10% early withdrawal penalty for those under age 59 ½ never applies to distributions from inherited traditional or Roth IRAs. Distributions due to death is one of 10 penalty exemptions for early distributions.

Talk to a knowledgeable adviser if you receive notice you will be inheriting an IRA.  Preferably an experienced retirement adviser. Making a mistake could mean the loss of the ability to take stretch payments or worse – a large tax bill on your inheritance. Click here to visit this article on Rick’s website.

Rick’s Tips:

  • Designated beneficiaries can stretch payments over life expectancy. Non-designated beneficiaries must use the 5-year rule.
  • Multiple IRA beneficiaries must split the IRA to take distributions based on each beneficiary’s life expectancy.
  • Even Roth IRA beneficiaries are required to take annual minimum distributions.

By Rick Rodgers

Sponsored by Willow Valley Communities

Stay informed by reading, Don’t Retire Broke, by Rick Rodgers. It’s “an indispensable guide to tax-efficient retirement planning and financial freedom”. You can purchase Rick’s book here.

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