How to Avoid the Pitfalls of Inherited IRAS

Death is a subject that most people dread thinking about. When a loved one passes away, the pitfalls of an inherited IRA will most likely be the last thing on your mind. Yet, proper estate planning and knowing what steps to take after a loved one dies are essential to managing your finances. Surviving spouses have some flexibility when it comes to inheriting an IRA, but non-spouse beneficiaries have limited options. Without proper planning, mistakes can be made, prompting large tax bills and forfeiture of tax-deferred growth.

Here are some of the common traps that can be avoided with planning and forethought:

FAILURE TO TAKE REQUIRED DISTRIBUTIONS
IRA distribution rules for inherited IRAs can be difficult to understand. Owners of traditional IRAs must begin taking required minimum distributions (RMD) when they turn 70 ½. Non-spouse beneficiaries who desire to extend the IRA over their own life expectancies must start RMDs the year following the owner’s death. Failure to take RMDs triggers a 50% penalty on the amount that should have been withdrawn for the year. If an RMD is missed in the first year following the owner’s death, penalties can be avoided by paying out the entire account within five years of the owner’s death (if the owner had not begun RMDs prior to death).

FAILURE TO TITLE THE ACCOUNT PROPERLY
Commonly, inherited IRAs are not titled properly. A non-spouse beneficiary is prohibited from simply rolling an inherited IRA into his or her own IRA. A separate account must be created with a title that details the decedent’s name and a note that the account is for a beneficiary. For example “Jane Doe (deceased March 1, 2015) IRA for the benefit of John Doe”. If the IRA is divided among beneficiaries, each new IRA must be retitled properly.  

FAILURE TO DIVIDE IRA AMONG HEIRS
IRAs are often inherited by more than one beneficiary. In a multiple beneficiary scenario, the beneficiaries should split the IRA, especially if there is a wide age gap among them. Failure to split will result in RMDs being calculated based on the age of the oldest beneficiary. For example, if one beneficiary is 59 years old and the other is 42 years old, both heirs will have to calculate RMDs based on the 59 year old’s life expectancy. This will shorten the years the money can grow tax deferred for the younger beneficiary. If the account is split by December 31 of the year following the owner’s death, each beneficiary is permitted to use his or her own life expectancy to determine RMDs.

If you have questions, do not hesitate to contact your Marcum professional.