IRA Heirs Beware Mistakes
Nonspouse beneficiaries who inherit an IRA should watch out for these common pitfalls.

It's easy to be distracted when a loved one dies, but you need to keep your wits about you if you're inheriting an IRA. Surviving spouses have some leeway, but nonspouse heirs must tread carefully. Make a mistake, and you could trigger a huge tax bill and lose your opportunity for a lifetime of tax-deferred growth. "There are a lot of little traps," says Jeffrey Levine, IRA technical consultant for Ed Slott and Co., which provides IRA advice. Here are some common pitfalls for nonspouse beneficiaries.
Failing to take required distributions. Owners of traditional IRAs must start taking required minimum distributions when they turn 70 1/2. Nonspouse beneficiaries of any age who want to "stretch" the IRA over their own life expectancies must start RMDs the year following the year the owner died. Heirs will have to pay tax on distributions of deductible contributions and earnings from a traditional IRA.
Also, while Roth IRA owners never have to take RMDs, nonspouse beneficiaries must. However, withdrawals from an inherited Roth IRA are still tax free.

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Not taking an RMD results in a 50% penalty on the amount that should have been withdrawn for the year. If you miss an RMD, you may avoid the penalty by emptying the account within five years of the owner's death. "However, depending on the size of the IRA and the age of the beneficiary, it might be smarter to pay the penalty than to liquidate the account simply to avoid the penalty," says Twila Slesnick, author of IRAs, 401(k)s & Other Retirement Plans (Nolo, $35).
Note, if the owner died after starting RMDs but had not yet taken the RMD for the year in which he or she died, the nonspouse beneficiary must take that RMD.
Titling the account improperly. Nonspouse beneficiaries cannot roll an inherited IRA into their own IRA. Instead, a separate account must be set up with a title that includes the decedent's name and the fact that the account is for a beneficiary, says Levine. For example, the account could be retitled to "John Doe (deceased December 12, 2012) IRA for the benefit of Jane Doe." If the account is split among beneficiaries, each new IRA must be properly retitled. And once the IRA is retitled, don't forget to name successor beneficiaries.
Not dividing the IRA among heirs. Be sure to advise your beneficiaries to split the IRA, especially if they have a wide age difference. If the account is not split, the age of the oldest beneficiary will be used to calculate RMDs, which will shorten the number of years the money can grow tax deferred.
Say the beneficiaries are a 75-year-old sister, a 50-year-old son and a 20-year-old grandchild. If the account remains whole, all the heirs will have to calculate their RMDs based on the 75-year-old's life expectancy. Instead, if the account is split by December 31 of the year following the year the owner dies, each beneficiary can use his or her own life expectancy to take RMDs—and can choose how to invest the money. "The distribution depends on age—the younger the beneficiaries are, the less they have to take out," says Mike Piershale, president of Piershale Financial Group, in Crystal Lake, Ill.
Ignoring non-person beneficiaries. 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 that share isn't paid out and the account hasn't been split, the rest of the beneficiaries can't take withdrawals over their life expectancies. They will have to empty the account within five years if the owner died before his required beginning date for taking distributions. If the owner died after that date, the beneficiaries must take annual RMDs based on the deceased's life expectancy, as noted in IRS tables.
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. Otherwise, the trust is considered a non-designated beneficiary and the same payout rules that applied in the previous scenario with the charity will kick in.
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