Q: What are my options if I inherit an IRA or benefit from an employer-sponsored plan?
A: You may not have given much thought to inherited IRAs in the past, but there is a good chance that you have or will someday inherit an IRA in the future.You can always take a lump-sum distribution, but that’s usually not the best idea. Although a lump sum provides you with cash today, it can also result in a huge income tax bill. A lump-sum distribution also removes the funds from a tax-deferred environment. Fortunately, you have other alternatives. So what are your options?
If you are a surviving spouse, you can roll over funds into your own traditional IRA or retirement plan. If you’re the sole beneficiary you can also leave the funds in an inherited IRA and treat it as your own, and defer taking distributions until age 70. You can also convert non-Roth distributions from an employer plan into a Roth IRA, but you will likely have to pay tax upon the conversion. You can also opt for one of the non-spouse choices, though these choices are often less advantageous.
Nonspouse beneficiaries have four choices.
1. You can take a lump sum distribution, which is typically fully taxable.
2. You can take any amount of distributions, but fully distributing within five years.
3. You can take annual distributions stretched over your remaining life expectancy. This life expectancy calculation will give you the minimum amount you must withdraw from the IRA or plan each year (you can always withdraw more than required in any year). Annual distributions must begin by Dec. 31 of the year after the year of the owner’s death.
4. You can disclaim the account. For some people it may be in their financial interest to not accept the inheritance, allowing the account to pass to another beneficiary or to go through probate. Talk to your financial advisers.
An employer-sponsored retirement plan can specify the distribution method that beneficiaries must use. Just because the tax code allow certain options doesn’t mean the custodian offers all the options. If your choices are limited by a plan or current custodian, consider moving the account to another custodian. Don’t trust the current custodian to give you all of your available options. He will likely only give you options that their company offers.
There are even times when beneficiaries are given information based on outdated laws. If the account is a company retirement plan, you may have to first transfer the plan funds to an IRA established in the deceased IRA owner’s or plan participant’s name. Then if your options are still limited, you may want to open an inherited IRA at another custodian and transfer the account (via trustee-to-trustee transfer). Your new custodian or financial adviser may offer assistance with these transfers, and some will even walk you through the process.
A few things to keep in mind:
1. Name your beneficiaries. Review and revise them over time as your life conditions change.
2. Don’t commingle with other assets. If you opt to move your account to another custodian, you cannot combine the (nonspouse) inherited IRA with other IRAs that you own.
3. There is no early distribution penalty from inherited IRAs. Though you will owe taxes as you take distributions, someone may mistakenly tell you that you will also owe an early distribution penalty.
4. There is no 60-day rule on rollovers of inherited funds like there is for traditional IRAs. If you are planning to move funds to another custodian, do not let the current custodian give you a check made payable to you which you cash and try to deposit to an inherited IRA. As mentioned above, try to do a trustee-to-trustee transfer. Otherwise you may have a fully taxable transaction.
5. If the account owner was required to make a distribution (RMD) in the year deceased but did not, you will have to make a distribution.
6. For many people stretching the distributions over your life expectancy is the best option so that you can take full advantage of tax deferrals. This option allows for long term growth of the account, and reduces your temptation to spend the money on current luxuries.
There are additional rules that apply if there were multiple beneficiaries on the account or if some of the funds were after-tax contributions. The rules governing inherited IRAs and employer-sponsored plan accounts can get complex. So, if the funds are significant, you should consult a financial professional for advice.
Travis Flenniken, a certified financial analyst, is vice president of investments at DeMoss Capital.