savings

Maximize an Inherited IRA

Beneficiaries can lose big tax advantages if they do not take the proper steps after inheriting an IRA.

EDITOR'S NOTE: This article was originally published in the July 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

There's a lot to like about inheriting an IRA, but the gift does come with strings attached. Beneficiaries, especially those who are not the surviving spouse, can easily lose big tax advantages if they do not take the proper steps soon after the death of the parent or other benefactor.

You can keep the money in the tax-deferred account and stretch out distributions -- and tax payments -- over a lifetime. You must take minimum distributions based on your life expectancy, but the rest of the account can grow tax-deferred.

Your first move when you are notified of your inheritance: Warn the IRA's custodian not to liquidate the account and write you a check. If that happens, you will pay tax on the entire account. "It's game-over then," says Rial Moulton, co-founder of Retirement & Tax Planning Specialists, in Spokane Valley, Wash.

Split, retitle and withdraw. If you are one of several beneficiaries, divide up the account. "Establish separate accounts so each can utilize their own single life expectancy," says Doug Zarookian, vice-president and New York branch manager for Charles Schwab.

You must split the account by December 31 of the year following the death of the IRA owner. If the IRA is not split, the size of the withdrawals will be based on the oldest beneficiary's life expectancy.

Say the primary beneficiaries of an IRA are a mother who is age 89 and children who are in their fifties. "Based on Mom's life expectancy, the IRA would have to be paid out rapidly," says Twila Slesnick, co-author of IRAs, 401(k)s & Other Retirement Plans (Nolo, $35). "It would be a disadvantage to the kids."

Nonspouse heirs cannot roll the money into their own IRA. You must open an account for an inherited IRA, and the title must include your name and the name of the person who left you the money. The inherited IRA should be named something like "John Doe's (deceased) IRA for benefit of Susan Doe."

Take special care if your parent named a charity as a beneficiary along with you and other beneficiaries. You must split off the charity's portion by September 30 of the year following the account owner's death. If you don't, the account must be emptied within five years after the owner's death.

A nonspouse heir's first required minimum distribution must be taken by December 31 of the year following the account owner's death. If you miss the deadline, the account must be paid out in five years. A beneficiary who inherits an IRA after the account owner began taking RMDs must take the owner's RMD in the year the owner died, if it was not already taken.

Rules for spouse. Spouses have more leeway than nonspouse heirs. They can either keep the inherited IRA in their deceased spouse's name or roll it into his or her own IRA.

For most spouses, especially younger ones, rolling the IRA into their own account makes sense because they can hold off on taking distributions until age 70 1/2. However, a spouse who is younger than 59 1/2 and taps the account will pay a 10% early-withdrawal penalty.

Younger spouses who need the money early would be better off keeping the money in the old IRA. "Once they attain 59 1/2, they could roll it over to their own IRA," says Zarookian.

Turning down the cash. If an heir, usually a spouse, decides she doesn't need the money, she can "disclaim" the IRA. The money will then pass to the other beneficiaries, usually the children. A disclaimer must be filed within nine months after a benefactor's death.

Because the spouse is refusing the money, the disclaimed amount won't count toward the spouse's $5 million federal estate-tax exemption. A spouse can disclaim a $5 million IRA, pass it on to children who are listed as beneficiaries, and still leave them another $5 million when she dies.

The younger the heirs are, the longer the money can grow. Consider a 20-year-old grandson who gets a disclaimed $50,000 traditional IRA. By taking out the minimum each year and assuming a 6% average return, the IRA could grow to $1.5 million over the heir's lifetime, Moulton says.

Most Popular

5 Fantastic Actively Managed Fidelity Funds to Buy
mutual funds

5 Fantastic Actively Managed Fidelity Funds to Buy

In a stock picker's market, it's sometimes best to leave the driving to the pros. These Fidelity funds provide investors solid active management at lo…
August 4, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
Amazon Ending a Key Perk for Amazon Prime Customers
Amazon Prime

Amazon Ending a Key Perk for Amazon Prime Customers

Got stuff stored on Amazon Drive? Heads up – that’s going away. Your photos are safe, though.
August 1, 2022

Recommended

IRAs vs. 401(k)s: Exceptions to 10% Penalty for Withdrawals Under Age 59½ Differ
IRAs

IRAs vs. 401(k)s: Exceptions to 10% Penalty for Withdrawals Under Age 59½ Differ

Before pulling money out of retirement accounts early, check the rules. The exceptions to penalties can differ depending on which type of account you’…
August 2, 2022
Should You Treat Your Kids Equally in Your Will? 12 Financial Planners Weigh In
retirement

Should You Treat Your Kids Equally in Your Will? 12 Financial Planners Weigh In

What's the "fair" way to divide an estate? Many parents think they should divvy things evenly among their children ... but that can backfire. So what'…
August 1, 2022
18 States With Scary Death Taxes
inheritance

18 States With Scary Death Taxes

Federal estate taxes are no longer a problem for all but the extremely wealthy, but several states have their own estate taxes and inheritance taxes t…
July 29, 2022
Don’t Name Your Estate as Your IRA Beneficiary
IRAs

Don’t Name Your Estate as Your IRA Beneficiary

It may sound like it makes sense, and it might be easier than picking a person (or two) to name, however there are some serious downsides to naming yo…
July 27, 2022