Critical Choices for IRA Beneficiaries

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Retirement account holders aren’t the only ones who need to plan how to make prudent investment selections, minimize taxation and strategize when to take withdrawals. Perhaps you are the designated beneficiary of a traditional IRA or recently inherited one. If you don’t effectively manage your inherited accounts, you may be penalized if you are unaware of the complex rules, restrictions and deadlines involved. You need that know-how to make crucial choices upon inheritance and avoid irrational last-minute decisions.

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While some beneficiaries may rush to liquidate their newly inherited funds by taking the lump sum option, it may cost 40% or more in immediate losses on the account balance from federal income taxes. Beneficiaries who have been allowed the option to continue growing their account values tax-deferred should consider doing so for as long as possible to postpone tax liability, although required minimum distributions (RMDs) generally must begin the year after inheriting the accounts.

What are Required Minimum Distributions (RMDs)?

RMDs are withdrawals you must take from your tax-deferred savings accounts once you reach age 70½. For traditional IRAs, people must take their first RMD in the year they turn 70½ (or at the latest by April 1 of the following year when taking your first distribution) and pay tax on the amount withdrawn. Subsequent RMDs must be taken every year before Dec. 31 as long as you live. (To see when your RMD is due, try our tool.)

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The RMD amount each year depends on your account balance at the end of the previous year and a life-expectancy factor that is generated from a table the IRS publishes yearly. If you don't take an RMD — or forget — a 50% penalty will be applied (e.g., a $1,200 penalty on a missed $2,400 RMD). (To calculate your RMD, try our tool.)

IRA spousal beneficiaries are subject to different distribution rules than non-spouse beneficiaries. Here are the options and differences between inherited IRA accounts:

Options for spouses

If you recently inherited an IRA from your spouse, consider converting the assets into a new account under your name. Or, if you already have an IRA of your own, you can roll the funds from your spouse into it. Either strategy can help you avoid RMDs until you reach the age of 70½ (although you can take withdrawals without paying an early-withdrawal penalty as soon as you reach the age of 59½). Remember to choose your own beneficiaries for a new account, or update your choices on an existing account. That’s something you should always do after major events like weddings, divorces, births, deaths or illnesses as beneficiary designation forms supersede the wishes set out in your will.

Even though spouses who inherit IRAs can structure them so that they don’t have to deal with RMDs until age 70½, it’s best to plan your tax strategy out well before that. While IRAs are great tools for tax-deferred growth, in the end, you will be taxed on not only your contributions, but the growth your account has delivered. Too much tax-deferred growth can maximize the balance in your accounts in the RMD withdrawal calculation, and the additional income from RMDs can push you into a higher tax bracket if you’re on the cusp. In some cases, the extra money from your RMDs can even cause you to be taxed on up to 85% of your Social Security benefits!

Another option surviving spouses can execute is to disclaim IRA account benefits and pass them on to children or grandchildren instead. By disclaiming an inherited spousal IRA, you don’t have to include the account balance in your own RMD calculation, which would trigger additional taxes. Passing the IRA down to your children and grandchildren can be a tax-efficient strategy, because even though they’ll have to pay taxes on the RMDs they’ll have to take, their life expectancies are much greater, and therefore the RMD is much lower.

Finally, consider converting your traditional IRA to a Roth IRA, that way you’re not subject to RMDs or Social Security taxation. While you’ll owe income taxes on the amount converted, if you’re already retired, your tax rate might already be low. In fact, many seniors whose only income comes from Social Security and possibly a small pension are in essentially a 0% tax bracket once all the exemptions and deductions are accounted for.

Roth IRAs are great because the money in the account can grow tax-free and any future withdrawals are tax-free as well, to you and your heirs.

Equal Shares for Heirs? Not Unless You Take Taxes into Account

Options for non-spouses

Non-spouse IRA beneficiaries are subject to special distribution rules. The first RMD is due by Dec. 31 of the year after the original account holder’s death. Keep a few other rules in mind:

Unlike original account holders, they are not subject to a 10% early-distribution penalty for withdrawing funds before age 59½.
RMD rules become complicated when there are multiple beneficiaries. If beneficiary accounts aren’t set up by Dec. 31 of the year after the original account holder’s death, RMDs will be based on the age of the oldest surviving beneficiary.
The 60-day rollover rule does not apply to beneficiaries. People usually use this rule to take a distribution from their IRA and put the money back in the same account within 60 days to avoid income taxes. For non-spousal beneficiaries, all withdrawals are taxed.
Different inherited IRA accounts cannot be merged into one (e.g., IRA and Roth IRA).

So, you can see that an IRA inheritance comes with a lot of considerations. Navigating all the options is a bit tricky, and making a mistake can be potentially costly. It’s best to learn about your options and make a plan well before the time comes, if you can.

What about inherited Roth IRAs?

Similar to traditional IRAs, inherited Roth IRAs are subject to almost the same exact rules with only one exception — all distributions are tax free! Since a Roth IRA is a retirement account, there are RMDs that must be taken every year and the 50% penalty still applies, regardless of its tax status.

It’s important to note that every retirement account has its own rules and you should be aware before making any sudden moves that can potentially disrupt what you’ve inherited.

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Carlos Dias Jr. is a financial adviser, public speaker and president of Dias Wealth, LLC, headquartered in the Orlando, Fla., area, but working with clients nationwide. His expertise spans a diverse clientele, including business owners, retirees, lottery winners and professional athletes with wealth management, tax planning, estate planning, long-term care, annuities and life insurance. Carlos has contributed to Kiplinger, Forbes and MarketWatch, and his work has been featured in CNN, CNBC, The Wall Street Journal, U.S. News & World Report, USA Today and other publications. He’s spoken at various CPA societies across the United States, and Carlos’ presentations often focus on innovative tax strategies, retirement planning and asset protection, providing valuable knowledge to accountants, attorneys and financial professionals.