A common financial fantasy is to receive an inheritance from a long-lost, unknown relative. It's the stuff movies are made of.
But what if your relative, or more commonly, your spouse has made you the beneficiary of their traditional or Roth IRA? There's no Hollywood script for that.
How you choose to receive distributions can have a major impact on your taxes.
Here are three general rules for all Inherited IRA's:
1. Uncle Sam will not wait for his cut of the pie. You may be required to take distributions. With an Inherited Traditional IRA (including SIMPLE, SEP and rollover) you will pay taxes on those distributions.
2. If you are transferring the inherited money to an existing or new account, the checks must be a direct "trustee-to-trustee" transfer. The option to rollover funds within 60 days is not available with inherited IRA's.
3. You must rename the account if it is inherited from anyone other than your spouse to clarify that the account is inherited. If there are multiple beneficiaries, a separate account must be set up for each person.
Let's look at one real-life example. Ellen, 80, and her husband Art had been our clients for years when Art passed away at age 84. Like many couples of their generation, Ellen was not involved in the family finances and needed to overcome a steep learning curve.
She had several accounts in her husband's name to deal with. Her husband's traditional IRA presented her with three options because her husband was over 70 ½:
Option 1 A Spousal Transfer to her own account, which would now be treated as her own. She would pay taxes on distributions as she does with other deferred income arrangements.
Option 2 She could open a new Inherited IRA and take distributions based on her own life expectancy, which is calculated the year after her husband's death and recalculated every year thereafter.
Since her husband had already been taking distributions up to the year of his death, she didn't have to worry about taking a distribution that year.
Option 3 Take a Lump Sum Distribution.
Ellen decided on the Spousal Transfer. If she had to open a new account and use the life expectancy method, she would be faced with high distributions due to her age. If she took the lump sum, she would jump up several tax brackets and end up paying a lot more in taxes as a result.
If Ellen's husband had been under 70 1/2 the options would have been similar, however a spousal transfer would mean a penalty would be applied if Ellen took a distribution before reaching 59 1/2 (unless she qualified for one of the IRS exceptions such as medical, education or home purchase).
Opening a new Inherited IRA had the same Life Expectancy Method, which would have smaller required distributions due to the younger age of the beneficiary. The additional option is using the 5 Year Method, which basically requires the account to be fully distributed within 5 years of the date of death.
Ellen's case is just one example of how complicated and potentially costly this can be. The key is to run the numbers to see which option is best.
In the case of a Roth Inherited IRA, this account will generally not be subject to taxes, but you can't leave the money in the account indefinitely. If you already have your own Roth IRA, you are never required to take minimum distributions.
If you are not the spouse of the deceased, you will have to take annual distributions based on your life expectancy, starting the year after their death. If you are the spouse, you can roll the Roth IRA into your own account. There is also the option to withdraw all the money within five years.
Retirement accounts are one of the trickiest parts of the IRS tax code, and the emotional impact of losing a loved one can only make things more difficult.Your tax situation is unique which is why your tax advisor should be one of the first calls you make.