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The person who receives an IRA when the owner dies is known as a beneficiary. Beneficiaries must include any taxable distributions in their gross income.
Rules To Remember:
A. Spousal IRA or NOT: If you inherit from a spouse, you can do one of 3 things:
- Treat it as your own, by designating yourself as the account owner.
- Treat it as your own by rolling it over into your IRA/ qualified employer plan/ qualified employee annuity plan/ tax-deferred annuity plan/ a deferred compensation government plan.
- Treat yourself as the beneficiary.
You will have chosen to have treated the inherited IRA as your own, if you made contributions into it including rollovers; did not take RMDs from it till the required age; if you are the sole beneficiary of the IRA & you have an unlimited right to withdraw amounts from it.
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If the inheritance is from someone who is not a spouse, you CANNOT treat the IRA as your own. The only recourse is then NOT TO TOUCH it, but to make a trustee to trustee transfer into an IRA that has been designated as an inherited IRA, for example, "Poppa Blue-eyes, deceased, inherited for the benefit of Sonny Bono, beneficiary".
You will then not to have pay taxes on the assets in the IRA, until you receive distributions from it. You must take distributions under the rules for distributions applicable to beneficiaries. The method to do so & rules are explained very well by Vanguard here. The custodian can be asked to split the inherited IRAs into separate accounts if there are more than 2 beneficiaries.
B. Beneficiary Forms: The form on file with the custodian of an IRA CONTROLS who inherits the IRA AND its ability to be taken over the life of the beneficiary. If people other than a spouse are named as heirs, they must begin taking distributions from the account by Dec. 31 of the year after inheriting, but these can be drawn out over the expected life spans of the beneficiaries. They too can enjoy years of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA by making proper arrangements with the custodian.
If your inherited IRA had named both primary and alternate individual beneficiaries (For Example: Spouse as primary and kids as alternates OR kids as primary and grand-kids as alternates), you, the primary beneficiary then have the option of “disclaiming” or turning down the account, enabling it to pass to the younger alternate. The custodians resort to their default policy if there is no beneficiary on file & send the funds directly to the estate. Different brokerage firms have different policies.
An important point to remember is that a beneficiary form overrides a will.
C. Estate As Beneficiary: Some name their estate as their IRA beneficiary, or inadvertently do so by failing to select a beneficiary. This cuts short the IRA's tax deferral. If the IRA is a Roth IRA, all funds must be withdrawn within five years. For a traditional IRA the same rule applies unless the former owner was already 70 1/2–the age at which a traditional IRA owner must begin cashing out. In that case the distribution rate for the heir is based on the age of the person who died.
D. Traps and Pitfalls:
- If the late IRA owner was 70 1/2 or older, beneficiaries must make sure the owner’s mandatory distribution for the year of death is withdrawn before doing anything else.
- When non-spousal beneficiaries take their own payouts, check if the estate paid estate tax, they may be able to take an itemized deduction to offset some IRA income. (Pub 559)
- For non-spousal beneficiaries again, the minimum distribution is calculated differently than for your own IRA. You take the balance on Dec. 31 of the previous year and divide it by your life expectancy listed in the IRS’ “single life expectancy” table, rather than the table used by IRA owners. The next year you use the same life expectancy, minus a year. (You use a different table for yourself every year.)
- Be mindful of key dates & deadlines outlined here.
Bibliography: Publication 590; Publication 559; Vanguard.com; Estate Planning Smarts by Deborah L Jacobs.
As always, read my disclaimer here. Please consult a qualified tax professional for your unique tax needs.
More of my contact information is on my website, www.mntaxsolutionsllc.com.