INCOME TAX PLANNING FOR INHERITED IRAs (Before 2020)
(This Article only applies to IRAs inherited prior to 2020)
You can transfer an IRA that you inherit from your spouse into your own IRA account, postponing required minimum distributions (RMDs), and taxes, until you turn age 70 ½. If you are over the age of 70 ½ years, you must begin taking the required minimum distributions, but you can continue to benefit from tax-deferred growth over your remaining lifetime.
Non-spouse beneficiaries do not have the option of rolling inherited IRAs into their own IRA accounts. If a non-spouse beneficiary wants to continue to benefit from tax-deferred growth, the beneficiary must be a "designated" beneficiary (see Estate Planning for an IRA), and must directly transfer his/her portion of the decedent’s IRA into a separate account known as an ‘Inherited IRA’, which comes with its own set of rules. If the estate is named as the beneficiary, the beneficiaries of the estate will not be able to stretch out the distributions from the IRA, but will be required to take all distributions within five years of the decedent’s date of death.
Special Rules for Non-Spouse Beneficiaries of Inherited IRAs
In order to maintain the tax-deferred status of an Inherited IRA, the non-spouse beneficiary must transfer the funds directly from the original IRA to the new Inherited IRA account. If you receive a check made out to you personally, you will be prohibited from depositing the funds into an Inherited IRA, and will have to pay income taxes on the entire amount. There is no 60-day window to deposit the money from the original IRA into a new inherited IRA account, as rollovers of withdrawn funds are not permitted. Once the money is safely in the Inherited IRA account, you have until December 31 of the year after the year of the original owner’s death to take your first distribution. If you miss that deadline, you may have to pay a penalty of up to 50% of the amount that you should have withdrawn. Additionally, if the original owner died after starting RMDs (required minimum distributions) but had not yet taken the RMD for the year in which he/she died, you must take that RMD in the year that the owner died.
Once you have established an Inherited IRA account and transferred the funds from the original IRA account, you can stretch the annual distributions (RMDs) over your life expectancy. A 50-year-old beneficiary, for example, could stretch distributions (and the life of the tax shelter) over the next 34 years. A 50-year-old beneficiary of a $100,000 IRA would be allowed to hold the first-year distribution to approximately $2,900, or less than half the amount that beneficiary would have to withdraw if the original owner was over 70 ½ years of age and left the IRA to his/her estate.
Be sure to split the IRA into separate Inherited IRA accounts for each beneficiary. If the account is not split, the age of the oldest beneficiary will be used to calculate RMDs, which will shorten the number of years the money can grow tax deferred. You have until December 31 of the year after the year of the original owner’s death to divide the account between the beneficiaries.
If you have inherited a Roth IRA, the Roth inheritance is usually tax-free, but you cannot leave the money in the account forever. The rules for withdrawals are the same as they are for traditional IRAs. If you transfer the money to an inherited Roth IRA account, you can usually stretch withdrawals over your life expectancy.
If you inherit an IRA, you can cash out the account at any time without paying an early withdrawal penalty, even if you are not yet 59 ½ years of age. However, unless you inherit a Roth, you will have to pay taxes on the money (except to the extent, if any, that the original owner made nondeductible contributions). A large withdrawal could push you into a higher tax bracket.
Taking distributions from an Inherited IRA based on your life expectancy will minimize the annual tax hit and maximize tax-deferred growth. You can find life-expectancy tables in IRS Publication 590, Individual Retirement Arrangements (IRAs). (Note: The life-expectancy factors are different than those used for non-Inherited IRAs.)
Planning for non-person beneficiaries
If an IRA includes a charity or other non-person entity as a beneficiary, the IRA must pay out that entity’s share by September 30 of the year following the owner’s death. If the charity or other non-person entity remains a beneficiary of the IRA after this deadline, the remaining beneficiaries cannot take withdrawals over their life expectancies. The remaining beneficiaries will need to complete all withdrawals from the IRA account within five years if the owner died before his/her required beginning date for taking distributions. If the owner died after that date, the remaining beneficiaries must take the annual RMDs based on the decedent’s life expectancy, as noted in IRS tables.
Special rules apply when a qualified trust is the designated beneficiary. You should consult with your attorney to confirm that the trust contains all necessary provisions to qualify as a "designated beneficiary". In addition to special provisions that must be included in the trust document, other special rules apply. For example, if a qualified trust is a beneficiary, the trustee will need to send a copy of the trust, or a summary of the trust provisions, to the IRA custodian by October 31 of the year following the year of the owner’s death. Otherwise, the trust is considered a non-designated beneficiary and the same payout rules that applied for charity or other non-person entities will apply.
The above is a summary of the general rules for IRAs. You should not rely on this advice as each person’s plan requires review for advice that would apply to their situations. Additionally, the rules and laws may change. You should consult with your tax or estate planner on a regular basis for current information and advice.