Inherited IRAs – What You Need to Know
-Written by Martin X. Shields, CFP®
It is becoming more common place for our clients to have an Inherited IRA as part of their investment portfolio. These accounts are IRAs that have been received from a spouse, parent or relative because the IRA owner selected them as the beneficiary of the IRA. Inherited IRAs can provide a significant benefit to the new account owner but there are a number of important elements to an inherited IRA that should be considered.
The first important determination is the selection of the correct primary and contingent beneficiaries while the account owner is alive. It is the beneficiary designation and not an individual’s will or trust documents that will determine how an IRA is transferred so it is important that the beneficiary designation is accurate. If there is no beneficiary designation then the transfer will be determined by the custodial agreement where the account resides.
The transfer of an inherited IRA primarily falls into 2 categories, spousal beneficiaries and non-spousal beneficiaries.
Spousal Beneficiaries
Spousal beneficiaries have the most flexibility with their decision on how to handle an inherited IRA. They can either keep the IRA in their spouses name or transfer the IRA to their name. If they transfer the IRA to their name they will take Required Minimum Distributions (RMDs) from the account when they reach age 70 ½. If they decide to rollover the assets to a beneficiary IRA, they would take distributions based on their own life expectancy but they would wait until the year after the decedent would have turned age 70 ½ to begin taking distributions.
Non-spousal Beneficiaries
Non-spousal beneficiaries can choose from the following three options for their distributions:
- Take the distribution as a lump sum
- Spread the distribution over five years
- Transfer the inherited assets to a beneficiary IRA
For most individuals, the 3rd option is the optimal one since the distributions are stretched over the beneficiary’s life expectancy. If there are multiple beneficiaries on the same account, it is important that a separate account for each beneficiary be, otherwise the distributions will be based on the oldest beneficiary’s life expectancy. Non-spousal beneficiaries can’t contribute to an inherited IRA but if multiple IRAs are inherited from the same person, they can be combined into one inherited IRA. However, you cannot combine assets inherited from different individuals.
One important item to remember is that although Roth IRAs do not have RMDs, inherited Roth IRAs do have RMDs that need to be taken annually. The upside is that distributions from a Roth IRA are not taxed.
As is evident from this article, the rules for inherited IRAs can be complicated so it is important to get professional guidance on how to properly handle these accounts. Failing to comply with IRS regulations can be very costly. If a required distribution from an inherited IRA is not made in the correct year, the penalty is 50% of the amount that was supposed to be distributed from the account – not a mistake you want to make.