For many, passing on unused retirement funds to a spouse or relative is a final gift of love. But IRA beneficiaries also face some serious financial obligations and major decisions, often at a stressful time.
We take a look at the complex decisions that can surround inheriting tax-advantaged retirement funds and consider why it’s important to get expert advice to make better long-term decisions.
DIGNIFIED CHOICES: PLANNING AHEAD TO INHERIT AN IRA
No one likes to think about what happens when a family member passes on, but it’s best to plan in advance for the financial repercussions of a death in the family. It’s wise to answer tough questions like “How do I avoid paying taxes on an inherited IRA ahead of time?” rather than amidst the emotion of a bereavement.
Most people assume an inherited individual retirement account (IRA) will work just like any other asset they may inherit from a loved one. However, there are many rules for inheriting an IRA that come into play depending on the specifics of the inherited account as well as your financial situation.
The wrong choices regarding an inherited IRA can cost you plenty in extra taxes and avoidable penalties. That’s why it’s important to take the time to research your options now. Then, when the time arrives, you will have a plan in place and won’t be caught by any surprises.
WHAT IS AN INHERITED IRA?
An inherited or beneficiary IRA is acquired or opened when you inherit any kind of pre-taxed or tax-deferred retirement plan (including employee-sponsored 401(k)s and regular and Roth IRAs) from a spouse, parent, or another relative.
HOW DOES AN INHERITED IRA WORK?
Inherited IRAs are retirement accounts created to receive, share, and distribute funds from an original IRA, but there are very different rules covering how this money can be handled depending on whether you are a surviving spouse, a minor child, or one of several inheritors.
It can also depend on whether the original owner of the account had reached the required beginning date to start receiving required minimum distributions (RMDs) from their account.
In fact, one of the few consistencies in inherited IRAs is that the account preserves the tax treatment of the original account. That means that money in a pre-taxed traditional IRA remains tax-free, while funds in a Roth IRA will still be taxed on disbursement.
As the designated inheritor of a retirement fund, you could face some important and urgent decisions regarding what might be a substantial sum of money following the death of your relative. It’s important to understand how the tax advantages and distribution rules of the account apply to you, and how your own financial situation might affect how you choose to use them.
While it can be tempting to simply cash out a policy rather than deal with complex tax and distribution rules, especially if you receive the money unexpectedly, this can be a costly choice.
At Wasatch Peaks Credit Union, we recommend sitting down with a qualified financial advisor to talk through your options before making any moves.
That said, let’s take a look at some of the potential choices you could face as the inheritor of an IRA account.
INHERITING FROM A SPOUSE
Surviving spouses or minor children of the deceased are the most likely inheritors of retirement funds and have the most options when it comes to deciding how to use those funds. There are two main routes that can be followed when deciding how to manage an inherited IRA.
1. SPOUSAL ROLLOVER
A surviving spouse can either change an IRA to their name or transfer all the funds to their own existing IRA, provided it has similar tax advantages. The transfer of funds needs to be done within 60 days of the departed spouse’s death to avoid any possible distribution taxes. Once transferred, the money continues to grow under the applicable tax benefits.
Transferring funds is the most popular option for surviving spouses. However, it is not always the best route. Surviving spouses cannot access transferred IRA funds without paying the 10% early-withdrawal penalty—in addition to deferred taxes—until they reach the age of 59½. Also, if the surviving spouse is 73 or older, they must take an annual required minimum distribution.
2. OPEN AN INHERITED IRA
With this option, the beneficiary of the original account opens a new inherited IRA account in their own name. This allows the surviving spouse to avoid the 10% early-withdrawal penalty even if they are younger than 59½ years old.
If the original owner had reached the required age for receiving RMDs, then their surviving spouse must start RMDs from the account before the end of the year in which the owner died. If the original owner had not yet begun receiving RMDs from their retirement savings, then the spouse beneficiary can now delay beginning distributions until the original owner would have turned 73.
There are three ways to take distributions from an inherited IRA:
- Distributed evenly over the rest of the beneficiary’s lifetime: Withdrawals are based on the beneficiary’s predicted life expectancy. You can also calculate life expectancy based on the original owner of the IRA which is a convenient way for spouses who are older than their departed partners to make their savings last longer.
- Over the course of 10 years: Under revised IRS rules, a spouse now has up to 10 years to use the remaining funds in an inherited IRA. Taxes are generally higher than even distributions but can be minimized by spreading out disbursals.
- Lump sum distribution: For tax-deferred traditional IRAs, the income tax on a single, full withdrawal of funds can be steep enough to offset any gains.
NON-SPOUSAL INHERITANCE
Inheriting an IRA from someone other than a spouse comes with its own set of rules. To inherit you must usually be an eligible designated beneficiary:
- A spouse or minor child of the deceased account holder
- A disabled or chronically ill individual
- An individual who is not more than 10 years younger than the IRA owner
Usually, these beneficiaries cannot choose to transfer the funds into their own inherited IRA or any other kind of account. Instead, they will need to begin taking distributions immediately. As with spouses, they can also choose to take distributions:
- Over their lifetime based on their life expectancy
- Within 10 years after the deceased’s passing, or
- Lump sum distribution
Beneficiaries of non-spousal inherited IRAs also cannot make new contributions to the account and they must begin taking any distributions by 31 December of the year following the death of the IRA’s original owner.
The exact amount that will need to be withdrawn annually depends on the inheritor’s age and expected life expectancy. Check out the IRS’s Single Life Expectancy Table to calculate how much you can withdraw each month from an inherited IRA at various ages.
Failure to withdraw the RMD funds can mean getting hit with a 50% penalty on the remaining distributions. For example, if you were required to withdraw $7,000 from an inherited IRA per year, but you only withdrew $2,000 one year, you will need to pay a full 50% penalty on the remaining $5,000.
That would mean a whopping $2,500 would go to Uncle Sam instead of into your Wasatch Peaks checking account!
MULTIPLE BENEFICIARIES
When there are several beneficiaries for a single IRA account, each beneficiary must open their own inherited IRA account and divide the funds according to the IRA agreement. In most cases, RMDs are then calculated according to each beneficiary’s age. If the assets aren’t divided before 31 December of the subsequent year, any RMDs are based on the age of the oldest beneficiary.
ROTH IRAS
Roth IRAs are not tax-deferred like traditional IRAs, so there is never any income tax to pay on qualified withdrawals. There are also no RMDs at play for the original account owner. RMDs will not affect the surviving spouse either, as long as they change the title of the Roth IRA to list their own name as the owner.
However, there are RMDs for non-spousal beneficiaries of Roth IRAs. These beneficiaries are required to begin taking distributions from inherited Roth IRAs in any one of the three manners listed above. If the money has been in the Roth IRA for more than five years, the beneficiaries will not be required to pay any taxes on these distributions.
It’s important to weigh your options now so that if you do become the beneficiary of an inherited IRA account, you pay a reasonable tax rate and can make the most of this valuable gift.
SMART IRA CHOICES: FOR YOURSELF AND OTHERS
As you can see, choices regarding funds inherited from a retirement account can quickly become complicated and there are serious implications to making unwise choices.
It’s wise to start planning early when passing on retirement funds or inheriting an IRA from a parent. That can mean having some frank discussions with relatives and also spending time with a Wasatch Peaks Credit Union financial advisor to ensure your remaining retirement funds are managed responsibly.
It can also mean taking the time now to set up a retirement fund that will serve your family’s needs deep into the future, even if you are just starting out. You might be surprised at the benefits. For example, did you know that some retirement account funds can be used to help fund your child’s college education or even double as an emergency fund?
At Wasatch Peaks, we offer our members a range of long-term savings products for every stage of life including traditional IRAs, Roth IRAs, and Coverdell Education Savings Accounts. Contact us today or click below to learn more.
