An inherited IRA should be handled carefully. The rules are complex and depend on the age of the IRA owner at death and whether the person inheriting the IRA is the spouse of the IRA owner or a non-spouse. Furthermore, distributions from a traditional, non-Roth IRA are taxable to the beneficiary after recovering any basis in the IRA remaining at the owner’s death.
Five Year Rule
All beneficiaries can elect what is known as the “five-year rule”. Under this rule, the entire amount of the IRA must be distributed by December 31st of the year containing the fifth anniversary of the IRA owner’s death.
If the beneficiary is a spouse
If you are a spousal beneficiary, you can take a lump-sum distribution under the five-year rule. The lump-sum distribution is taxable income if not a Roth IRA. Some states might exempt IRA distributions from taxation. Another option for the spousal beneficiary is to roll over the IRA to his or her own IRA account or a separate inherited IRA account. Separate inherited IRA accounts name the deceased account owner with a for the benefit designation of the spouse or other beneficiary.
If the owner was age 70 1/2 or older, the spousal beneficiary has the option to take distributions over the longer of the spouse’s life expectancy or the owner’s life expectancy beginning in the year following the owner’s death. If the owner was younger than 70 ½ years old at death, the required minimum distributions (RMD’s) must start by either the year following the year of death or the end of the year that the owner would have been 70 ½ years old, whichever is later. In this case, the spousal beneficiary only has the option to take the IRA out over their life expectancy.
If the owner did not take out their RMD in the year of death, it must be distributed to the beneficiary by December 31st in the year of death.
If the beneficiary is a non-spouse
If the beneficiary is an individual non-spouse, the non-spouse has the same options as a spouse beneficiary except the non-spouse cannot rollover the IRA to his or her own IRA. If the beneficiary decides to take out the IRA funds over under the life expectancy method, the IRA must be retitled as an inherited IRA separate from any other IRA accounts of the beneficiary.
If the beneficiary is a non-spouse or the spouse is one of multiple beneficiaries and the owner was younger than 70 ½ years old, the IRA can be distributed over the life expectancy of the oldest beneficiary. If the owner was older than 70 ½ years old, the distributions must be taken over the remaining life expectancy of the owner or the life expectancy of the oldest beneficiary – whichever is longer. It is recommended to divide the IRA account into separate accounts if there
are multiple beneficiaries. The IRA account must be divided by December 31st of the year following the IRA owner’s death.
RMD rules do not apply to the owner of a Roth IRA, but they do apply to beneficiaries who inherit a Roth IRA. The Roth IRA distribution options for beneficiaries are the same as the options for traditional IRA’s.
If the beneficiary is an estate
An estate can be named as a beneficiary of an IRA but is generally not recommended. If the owner dies before 70 ½ years old, all of the funds must be withdrawn by December 31 of the fifth year following the year the owner dies. If the owner dies after 70 ½ years old, whoever inherits the IRA must take distributions as fast as the owner would have taken them. The estate cannot stay open until indefinitely, so many times the IRA is cashed out under the five-year rule creating taxable income for the estate or its beneficiaries if the IRA is not a Roth IRA. Additionally, the costs of administering the estate will increase as the IRA is considered a probate asset and is subject to probate fees.
If the beneficiary is a trust
Like estates, a trust can be a beneficiary of an IRA but again, it is generally not recommended.
A “qualified” trust” with designated beneficiaries can follow the same distribution rules for multiple beneficiaries based on the life expectancy of the oldest beneficiary. A problem naming a trust as the beneficiary of an IRA is the trust beneficiary cannot name new beneficiaries. For example, if a trust is set up to benefit a spouse and the trust is the beneficiary of the owner’s IRA, the spouse cannot roll over the account into his or her retirement account and name children or anyone else as beneficiaries unless the trust is a “qualified trust” with the spouse as the sole lifetime beneficiary. Even if the spouse is the sole lifetime beneficiary of a “qualified trust”, many IRA custodians do not want to make the call as to rollover eligibility and will refuse the rollover.
If the beneficiary is a charity
A charity can be an IRA beneficiary. After the IRA owner dies, the charity must take out all the money within five years if the IRA owner died before age 70 ½ years old. If the owner died after age 70 ½ years old, the charity must take distributions based on the owner’s life expectancy.
It’s important to understand what options exist for an IRA beneficiary so as to distribute out the IRA funds in the most tax efficient manner as possible. Failure to distribute IRA funds after the owner’s death according to rules outlined above can subject the beneficiary to penalties. Be sure to speak with your tax advisor if you need any advice.
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