The Inherited IRA: Part One


Setting up an IRA is very easy. Moreover, the tax rules for the benefits received from them are also easy to understand. What is more complicated are the rules for inherited IRAs. Yet, understanding these rules can be crucial. The rules vary depending on whether you inherited the IRA from your spouse or from someone else, such as a parent. Accordingly, due to the length of this discussion, I will be breaking this topic down into two parts. The first part, presented today, will deal with inherited IRAs from a spouse. In the next post, I deal with the planning necessary if you inherit an IRA from someone other than a spouse, such as your parents. These have some very different rules and do require careful planning.

If you inherit an IRA from your spouse: You have two choices: you can elect to either receive distributions over your deceased spouse’s lifetime, or roll the IRA into your own and take distributions over your own lifetime, which is usually the better choice.

The decision typically hinges on whether the surviving spouse has turned 59 1/2 and whether his or her spouse had turned 70 1/2 before they died. “Based on those two dates, it tells you what to do with the account,”

A spouse who is younger than 59 1/2 and needs the money would be better off remaining a named beneficiary. If she rolls the money into her IRA and then withdraws any of it, she’ll pay a 10% penalty until 59 1/2. Instead, if she remains a named beneficiary, she can tap the account without penalty. To be a named beneficiary, she must re-title the account as an inherited IRA. If the IRA is treated as their own IRA, generally no withdrawal can be made penalty free if the inheriting spouse is under age 59 1/2. Thus, making it their own IRA will be fine if the inheriting spouse is at least 59 1/2.

NOTE: The inheriting spouse is not locked into that option,” At any time, he or she can roll the money to her own account.

A surviving spouse who is older than 59.5 but younger than 70 1/2 and doesn’t need the money generally should make the IRA her own. She won’t be required to take minimum distributions until she turns 70 1/2. All the rules apply as if she owned it since day one.

If he or she needs the money, they can take withdrawals over their previous spouse’s remaining lifetime without an early withdrawal penalty.

The age of the account owner at death also could influence a surviving spouse’s decision. If the owner died before the date she was required to begin distributions, a spouse who remains a named beneficiary will not have to take distributions until the year that his late spouse would have turned 70 1/2. (The “required beginning date” for taking distributions is April 1 of the year after the owner turns 70 1/2.)

Assume a 64-year-old wife leaves a traditional IRA worth about $530,000 to her 74-year-old husband, and he keeps it as an inherited IRA. Six years later, when his wife would have turned 70 1/2, he takes his first Required Minimum Distributions (RMD) of about $70,000, based on his own life expectancy. At 90, he would have about $300,000 in the account.

A survivor’s decision to roll the IRA into her own or keep it as an inherited IRA can have a big impact on the next generation. If the IRA becomes your own, your beneficiaries can use their own life expectancy to take distributions when they inherit the money. Your beneficiaries can also “stretch” distributions over their lifetimes if you kept the account as an inherited IRA but die before your deceased spouse would have turned 70 1/2.

But if you kept the account as an inherited IRA and you die after you start RMDs, your beneficiaries will have to take RMDs based on the life expectancy you were using. That means your younger beneficiaries will have lost the chance to stretch the IRA over their lifetimes.

Bottom line: Generally, unless you need the money and are under age 59 1/2, you are usually better off rolling over the inherited IRA into your own IRA. However, as you can see, this isn’t an easy decision. It is also fraught with traps for people who don’t know the rules. I would advise anyone who inherits an IRA to see a good financial planner or tax professional who knows the rules. At least with this post, you can make some informed decisions with your planner, which should make your life less taxing. You may also want to print out this post and the one on Wednesday in order to have this available as a reference.

In Part Two, I discuss the the tax implications and planning available if you inherit money from someone other than your spouse. So stay tuned.

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