Taxes and Other Considerations When You Inherit an IRA

Cambridge Trust

July 26, 2018

Financial Planning

Are you likely to inherit the assets in an Individual Retirement Account or IRA? If so it’s important to know the rules for the transfer of those assets to avoid unnecessary delays and to minimize their income tax impact. 

In fact, the IRA you inherit will be handled differently depending on whether you are the spouse of the prior owner or a non-spouse beneficiary. Here’s a quick review:

Two Choices for Spouses Who Are IRA Beneficiaries 

If your spouse dies, leaving either a Traditional or a Roth IRA that names you as the sole beneficiary, you have two choices: 

1. You may roll the IRA into your own IRA, a process called a “Spousal Rollover”. A rollover may be carried out at any time; there is no deadline. Once the rollover is completed, all of the standard IRA rules will apply.

OR

2. You may continue your spouse’s IRA account with yourself as the beneficiary. However several 

exceptions to the standard IRA rules apply, as follows:

  • ​There is no 10% early withdrawal penalty, regardless of your age.If you inherit a Roth IRA, the “five-year holding period rule” must still be satisfied. Any withdrawals taken before the time at which the deceased owner would have satisfied this rule will be subject to income tax.
  • If you inherit a Traditional IRA, you must begin taking Required Minimum Distributions (RMDs) on the schedule of your deceased spouse, not in the year that you would have been required to begin distributions based on your own age. However, the amount of the RMD will be based on yourlife expectancy, which may be most beneficial if you are older than your spouse.


Rules for Non-Spouse IRA Beneficiaries

For all other IRA beneficiaries, the transfer of an IRA involves creating an entirely new “Inherited IRA” account after the death of the original account owner. The Inherited IRA[1]gives non-spouse beneficiaries the ability to stretch out the benefits of an IRA as long as possible and delay taxation for many years. 

However, because poor handling may result in immediate income taxation, it’s important to manage the transition to an Inherited IRA carefully to optimize its value and avoid paying unnecessary taxes. 

When you receive IRA assets as a non-spouse beneficiary/owner, the new Inherited IRA account works much like a Traditional IRA, EXCEPT that:

  • You won’t pay a 10% early withdrawal penalty, regardless of your age.
  • You can’t roll an Inherited IRA into your own Traditional or Roth IRA (as a spouse can).
  • You can’t consolidate IRAs that you inherit from different people in one account. Each Inherited IRA must be held as a separate account
  • If you inherit a Roth IRA, the “five-year holding period rule” must still be satisfied. Any withdrawals taken before the time at which the deceased owner would have satisfied this rule will be subject to income tax
  • Any Required Minimum Distributions (RMDs) that [you or the deceased owner] must take will start in the year after the death of the original account owner. These distributions may be taken over your remaining life expectancy or over five years. But you must select which option you prefer.
  • If you should die before the assets in your Inherited IRA account have been fully distributed, your successor beneficiary who inherits the IRA will be subject to the same rules you were, except that your successor beneficiary will have to take RMDs each year as if he or she were the original beneficiary


Options for Multiple Beneficiaries

 If multiple beneficiaries (which may include a spouse-beneficiary) inherit an IRA and keep their interests commingled,only the oldest beneficiary can optimize the tax-deferral benefits of the Inherited IRA. In this case, the age and life expectancy of the oldest beneficiary will be used to calculate the account’s RMDs for all beneficiaries, effectively reducing the “stretch” period of the IRA for all the others. In addition, any spouse beneficiary in the group will be treated as a non-spouse beneficiary. 

However, if the IRA is split into separate Inherited IRAs, all of the beneficiaries may treat their portions as if they were the sole beneficiary. In this way, each beneficiary uses his or her own life expectancy for calculation of RMDs, and any spouse beneficiary has more distribution options than a non-spouse beneficiary. (The deadline for splitting a single IRA into separate Inherited IRAs is the end of the year following the deceased owner’s death.)


Account Title, Tax ID, and Other Considerations for Inherited IRAs

It is also important to include both the name of the deceased owner and the name of the beneficiary/new owner in the account title for an Inherited IRA.

Examples are: 
--Mary T. Jones F/B/O John M. Smith Inherited IRA (preferred format)
--Mary T. Jones Inherited IRA F/B/O John M. Smith
--Mary T. Jones, deceased, Inherited IRA F/B/O John M. Smith
 
In addition 

  • The Social Security number/tax ID for the Inherited IRA should be that of the new beneficiary.
  • Assets being rolled over from the original IRA to the Inherited IRA account (or accounts) should be identified as a Direct Transfer to avoid any possibility of being taxed as a distribution. This is particularly important when moving the assets from one financial institution to another.
  • The owner of a new Inherited IRA should designate a new beneficiary or beneficiaries at the same time that the new account is set up to avoid any possibility of a lapse in beneficiaries.
  • As always, your Cambridge Trust Relationship Manager is available to discuss this topic as well as other wealth planning issues.
[1] Effective for all transfers after 12/31/2006, the Inherited IRA was created by the Pension Protection Act of 2006. 


This article is for informational purposes only and should not be construed as investment or legal advice.