A situation that we have been seeing more and more of is people inheriting IRAs from loved ones. In this article, we will focus on non-spouse beneficiaries of IRAs. A couple of examples of this could be adult children inheriting an IRA from a parent, a brother inheriting an IRA from his sister, or a friend inheriting an IRA from a friend. Please note, we are not discussing spouses inheriting IRAs from spouses, entities inheriting IRAs (i.e. trusts named as beneficiary), or someone inheriting a workplace retirement plan. Those all have different rules and options related to them. However, if you find yourself the non-spouse beneficiary of an IRA, here are a couple of items to be aware of.
• Understand Your Distribution Options – Typically, when someone inherits an IRA from a non-spouse, they mistakenly believe that their only option is to take the money as a lump sum distribution and pay 100 percent of the taxes in year one. However, taking a lump sum is just one of a few distribution options that are typically available to a non-spouse beneficiary. If the account owner passed away prior to age 70 1/2 the non-spouse beneficiary may have the option to elect what’s called the five-year rule. Essentially what that allows the beneficiary to do is take withdrawals as needed (or none at all) for five years. However, the entire account must be distributed by Dec. 31 of the fifth year after death. Distributed assets are subject to ordinary income taxes and taxable as such. A third option, and typically the most advantageous in the long term, is for the beneficiary to set up what’s called an Inherited IRA and use the life expectancy method. With an Inherited IRA, the beneficiary is required to begin taking required minimum distributions (and pay all applicable taxes on those distributions) from the inherited assets beginning by Dec. 31 in the year following the year of death of the original owner. What is nice about this option is the flexibility it provides the beneficiary. The IRS sets guidelines on the minimum that must be distributed each year, but the beneficiary can take out more than the minimum each year if their circumstances require it. However, perhaps the biggest advantage of an Inherited IRA is that it allows the beneficiary to keep the remaining assets that are not required to be withdrawn each year in an account that can continue to potentially grow tax-deferred throughout the years.
• Be Aware of Common Mistakes – If you are the non-spouse beneficiary of an IRA, the choices can seem daunting and it’s important to understand what you are doing because a mistake can potentially have irreversible consequences. A common mistake is for non-spouse beneficiaries to commingle the IRA assets they inherited with their own traditional IRA. This is not allowed, you must keep these assets separate. Another mistake seen is people improperly transferring Inherited IRA assets. If you have an Inherited IRA established at XYZ custodian, but would like to move the account to ABC custodian, it must be done via trustee-to-trustee transfer, meaning the proceeds never touch your hands. The current custodian will make the check payable to the new custodian, not to you. Unlike with traditional IRAs that allow for one 60-day rollover every 12 months, this is not allowed with Inherited IRAs.
Being the beneficiary of an IRA creates a situation where you need to make decisions about how to receive that money. Since it usually comes as a result of the passing of a loved one or a close friend, it can be a difficult time. Make sure you know your options and the tax consequences before you make a final decision. Work closely with a tax or financial professional and coordinate with the current custodian of the IRA. Although the custodians of IRAs are careful to not generally give tax advice, they can be very helpful in explaining what options you have available to you for receiving the inheritance.
Gary E. Croxall, CFP®
Soren E. Croxall, CFP®
Croxall Capital Planning
Securities and Advisory Services offered through National Planning Corporation (NPC), member FINRA/SIPC, a Registered Investment Advisor. Consulting and Investment Management offered through Croxall Capital Planning (CCP), a Registered Investment Advisor. CCP and NPC are separate and unrelated companies. NPC and CCP do not provide tax or legal advice. The information contained herein is for general education and is not intended as specific advice or a recommendation to any person or entity. Diversification cannot ensure a profit or protect against a loss. The opinions expressed in this article do not necessarily reflect those of NPC.