Handling an estate is never easy. The emotional toll of losing a loved one and the mental toll that comes with navigating the waters of an estate resolution can be a lot to bear. One of the most complex aspects is if you’ve inherited an IRA, which puts you in the trifecta of tax planning, estate planning, and financial planning.
Each financial responsibility is onerous individually, but an inherited IRA combines all three and the difficulty each entails. A mistake can be extremely costly, and the IRS is not known for giving second chances. Here are five things beneficiaries should know about inherited IRAs.
Know Your Beneficiary Status and the Rules Associated With It
IRA Key by Rusty Wallet licensed under CC BY 2.0
A surviving spouse has a few options when inheriting an IRA. They can either:
- Name themselves as owner.
- Roll it over to another IRA or other qualified plan.
- Act as the beneficiary of the IRA.
Only the surviving spouse has these options; others who may inherit an IRA don’t. If you opt to roll it over, it resets the IRA, and you can name your beneficiaries.
It bears repeating that you need to take action and understand the ramifications to avoid running afoul of the IRS regulations. Rules differ as well depending on your beneficiary status. There’s a type of beneficiary known as an eligible designated beneficiary, which refers to those who are a minor child, disabled or chronically ill, or not less than 10 years younger than the original IRA owner. Much like spouses, designated beneficiaries have their own rules that differ from the other groups. Designated beneficiaries have two options:
- Transfer to an IRA in your name and take required minimum distributions (RMDs) over the course of your life expectancy.
- Transfer to an IRA in your name and take distributions for ten years. There’s no RMD, but you must have liquidated the account by December 31st, 10 years after the original IRA owner’s death.
Typically, the first option is the best choice, as you can continue to grow your funds for years or even decades while only taking out RMDs. The second option can lead to much higher costs in income taxes if the IRA is not a Roth, and a Roth IRA will have already had taxes paid on the front end. Part of the complexity involves making sure you follow the regulations while considering the tax impact of large withdrawals versus only taking RMDs over time and letting the money grow.
It is certainly allowable to list a trust as the primary beneficiary of an IRA. Still, without proper care and attention, this can go awry and limit the options available to the beneficiaries. Without adequately delineated provisions, a custodian may not be able to determine who the beneficiaries are, and then the IRA’s accelerated distribution rules would now apply.
Determine Year-of-Death Required Minimum Distributions
Yet another consideration for someone who has inherited an IRA is whether the benefactor had taken their own RMD the year they passed away. If not, the beneficiary must make sure the minimum has been met, and if not, they must withdraw the requisite funds to meet the RMD requirements. If not, you can be subject to a 50% penalty for the shortage.
This consideration can be especially problematic if the death occurs later in the year. You may not even know you have inherited the account until after it’s too late to rectify the situation. However, if the decedent was not yet required to take out any minimum distributions, then this year-of-death required distribution doesn’t apply.
Use Available Tax Breaks
It’s a good possibility that the inherited IRA is taxable unless it’s a Roth IRA. You will have a regular income tax to pay on distributions for traditional IRAs. If the estate was subjected to estate tax, the IRA inheritor could claim an income tax deduction in the amount of the estate taxes already paid on the IRA. This taxable income that the decedent has never received is referred to as income in respect of a decedent.
Be Diligent Regarding the Beneficiary Forms
If you have failed to fill out a designated beneficiary form or are incomplete or unclear, it can quickly derail an estate plan. Most will have assumed they’ve already filled it out correctly when they actually have not. But often, it’s incomplete or hasn’t been submitted to the custodian.
Failure to have a properly completed beneficiary form will cause the beneficiary to be subject to the five-year rule regarding distributions once the account goes to the estate. The form is typically straightforward, only requiring minimal identifying information. But don’t let its simplicity mislead you since this form can potentially control the distribution of a large sum of money.
Understand Roth IRAs Are More Tax-Friendly in an Estate Proceeding
An oft-overlooked benefit of a Roth IRA is the tax advantages it presents in estate proceedings. Due to the inherently complex nature of inherited IRAs, anything that can simplify the process is of great value, and a Roth IRA can do just that. A Roth allows the tax-free transfer of funds to beneficiaries so the beneficiary won’t be taxed on the principal. You can take a tax-free lump sum withdrawal if you meet the five-year holding requirement. Remember to consider other tax issues. For instance, a spouse who treats a Roth IRA as their own would then have to pay taxes on withdrawals.
It can be a tremendous financial windfall to inherit an IRA, especially a substantial one. You might be able to grow that account for decades and take advantage of tax-favorable compounding. However, it can be wrought with pitfalls that are easy to fall into as you work your way through the process. While a simple internet search can answer many questions, hiring an advisor may be the most fiscally prudent way to maximize your return on the newly inherited investment.
If you’ve inherited an IRA and have questions, reach out to the experts at 3D Wealth Advisors. We provide financial advice on services such as estate planning, investment strategies, and tax planning and preparation. Call us at 808-818-7561 or complete our secure and convenient online form to get started.