A client recently contacted me for advice on a sticky situation. Both she and her husband had inherited IRAs from their mothers who had passed away 6 and 11 years earlier respectively. By sheer coincidence, the wife discovered that they both should have been taking RMDs or Required Minimum Distributions from these accounts per IRS rules. However, their other advisor had never informed them of this requirement. Consequently, they are now facing the task of calculating how much should've been taken out of those accounts over the past 6 and 11 years, plus pay a 50% tax penalty for each one of the distributions that should have been withdrawn!
The rules regarding inheriting IRA Accounts are quite complex, and as the above example illustrates, can be very costly, if not followed properly. It’s likely that with the coming transfer of wealth over the next several years, many of us will also be inheriting IRA assets. So, here are some high level points you’ll need to know if you are inheriting an IRA.
What was the age of the IRA account owner at the time of death? The distribution rules vary greatly depending if the IRA owner was over or under 70 ½. If over 70 ½, you’ll need to make sure that the owner took their RMD (Required Minimum Distribution) in the year of death, since that distribution is mandatory before any other withdrawals take place.
Surviving spouses have the broadest and most liberal withdrawal options vs. those for non-spousal beneficiaries. Surviving spouses can either retitle the IRA account in their own name, consolidate and rollover into their own IRAs, or establish the account as a beneficiary of inherited IRA account. With this last option, and depending on the age of the deceased spouse, funds can be withdrawn either in a lump sum, over five years or over their own life expectancy. This option could be preferable if the spouse is younger than 59 ½ and needs to access the IRA funds. Although withdrawals are taxable, they would avoid the pre- 59 ½ 10% tax penalty.
Gift of a Lifetime
Non–spousal beneficiaries have fewer options than spouses, but can still benefit from a few different rules that could help to create wealth over your lifetime as well as potentially for your loved ones. Following the rules to a “T” will help avoid some unfavorable tax consequences. Borrowing from the first point, the age of the IRA owner determines what withdrawal options the beneficiary can employ. If under 59 ½, the beneficiary can elect to take funds in a lump sum, receive the funds over a 5 year period or take distributions over their own life expectancy, otherwise known as the “stretch IRA” strategy. If, on the other hand, the owner was 70 ½ and older, the beneficiary only has two options: take in a lump sum or take funds out over their own life expectancy.
No matter which option is elected, keep in mind that any withdrawal is subject to regular income taxes. With the exception of the spouse electing to consolidate into his/her own IRA account(s), beneficiaries younger than 59 ½ , the 10% penalty is waived. Furthermore, there are also some very specific time frames that must be adhered to, when making your election, otherwise, it could jeopardize your withdrawal plan. Bottom line, don’t go it alone. Consult a financial planner and your tax advisor for advice and direction. Once you make an election, it could be irrevocable and/or difficult to unwind.