The COVID-19 pandemic has forced many families to unexpectedly settle an estate after the untimely death of a loved one. If you have recently inherited an individual retirement account (IRA), you may not know what rules apply. The rules for inherited IRAs are different than those that apply to other IRA accounts as well. Inheriting an IRA can leave you trying to navigate the rules of estate planning, financial planning, and tax planning simultaneously. Making a wrong decision can cause expensive consequences. If you make a mistake, you may struggle getting the IRS to give you a do-over.
Here are 10 things you need to know if you inherit an IRA from someone other than your spouse.
1. Consider all your options before doing anything with your inherited IRA. You have time to make decisions. You do not need to rush. First, you want to make sure IRA custodian (often a brokerage firm) has been notified of the IRA owner’s death. You want to make sure the beneficiary account is set up properly as well. The account title should read: “[Owner’s name], deceased [date of death], IRA FBO [your name], Beneficiary” (FBO means “for the benefit of”). Putting the account in your name is treated as a distribution. The full value of the account is immediately reported as income. It’s very difficult to undo this error.
2. Find out if the decedent took any required distributions in the year they died. Let’s say your father died on January 15, leaving you his IRA. He probably had not taken his distribution yet. As the beneficiary, you must take it if the original owner didn’t. If you don’t know about or forget this rule, you are liable for a penalty of 50% of the amount not distributed. This can be harder to determine on a timely basis if someone dies late in the year. What if your father dies on December 15 and hasn’t taken his full distribution? You may not even find out that you inherited the account, or if you do, you may not know how much he has taken year-to-date. The last day of the calendar year is the deadline for taking that year’s RMD. (Note that if the deceased was not yet required to take distributions, then there is no year-of-death required distribution.) If the account is shared by several beneficiaries, any year-of-death distribution can be allocated based on the wishes of the group.
3. You cannot make any contributions to your inherited IRA. Special distribution rules apply to inherited IRAs. These rules mean you cannot make contributions to an inherited IRA. You also cannot commingle inherited IRAs. If you inherit IRAs from different owners, they cannot be combined into a single inherited IRA. If they are inherited from the same owner, you may be able to combine them.
4. You can move your inherited IRA. If you don’t like the investment choices offered by the custodian where the account was held, you can move the account. You can also transfer the account if you prefer to work with a different custodian. You can invest the account in any way allowed by the custodian that holds the account. You must move the account by direct transfer. The new account must also be an inherited IRA titled the same way as noted above. The rule allowing you to take a distribution and roll it over within 60 days (the 60-day rule) does not apply to inherited IRAs.
5. No Roth conversions. Unfortunately, you cannot convert an inherited IRA into a Roth IRA.
6. You will have to take distributions within a prescribed period. If you inherited the IRA before 2020, you must take annual RMDs. (Note: the CARES Act waived the RMDs in 2020.) These RMDs are based on your age at the time you inherit the IRA. The IRS provides tables to help you calculate the amount. If you inherit the funds in 2020 or later, you will most likely be subject to a 10-year payout period. These rules do not impose specific distribution requirements in any one year. But the account balance should be zero after 10 years have passed. When deciding when to take distributions, you should take your financial plan and tax situation into account.
7. You can make a qualified charitable distribution (QCD) from an inherited IRA. If you are charitably inclined and age 70 ½ or older, you may be able to use QCDs to lower your tax bill. QCDs require you to move your funds directly to the charity of your choice in a tax-free transfer.
8. Don’t worry about penalties. For regular IRAs, you generally must pay a 10% penalty if you take distributions before age 59 ½. This early distribution penalty does not apply to inherited IRAs. If you inherit a traditional IRA or 401k, the distributions are subject to regular tax only.
9. What if you inherit a Roth IRA? You still have to withdraw the funds over the prescribed period. (10 years if you inherit the account in 2020 or later.) Distributions will most likely be tax-free.
10. Don’t forget to name a successor beneficiary. When you inherit an IRA, you should name a beneficiary. If you don’t, the default provisions in the IRA document are likely to apply. As with most financial accounts, designating a beneficiary can keep the assets out of probate. This can save both time and money.
Knowing what to do when you inherit an IRA can be complicated. You must consider your current financial and tax situations. Estate planning considerations can apply as well. If you have inherited an IRA and have some questions, please schedule a free call.
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
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