There are about 25 million Individual Retirement Accounts in the United States, representing more than $2.5 trillion in total assets. Given the fact that they can only be held by one individual, the odds are good that you may find yourself the recipient of an IRA account at some point. And since they are strictly governed by a special set of rules, you will want to carefully observe the rules of the road as a beneficiary of an inherited IRA. Mistakes can be costly in terms of taxes and possibly even IRS penalties if you run afoul of the rules.
Christopher HopkinsFirst, the rules are different and much simpler for spouses. If your deceased husband or wife named you as the beneficiary, you may simply assume the account as your own. In the event that you have an existing IRA, your spouse's account can be rolled directly into your own account of the same type (Roth or traditional). If you do not have an IRA account of your own, the inherited account can be retitled and assumed as your own with all the tax-deferral characteristics intact. Simple.
It gets more complicated if you are a non-spousal beneficiary. You will not be able to simply roll the assets into your own account, because the tax code requires that the money must eventually be distributed (Uncle Sam needs the revenue).
Basically, you have three choices. First, you may simply choose to cash in your chips and pay the taxes. Assuming a traditional (tax-deferred) account, you will declare the proceeds as income on your tax return. This is generally the least favorable outcome, as your distribution will be taxed at the highest marginal tax rate to which you are subject, and may easily propel you into a higher bracket.
Assuming you do not wish to distribute the entire amount, you will establish what is called an "inherited" IRA account and roll over the proceeds. At this point the clock starts running on the other two options.
The tax code provides that you may fully distribute the balance at any time within five years after the year of death, at any pace you choose. Any distributions are taxable as they occur, but this allows you to reduce the tax bite by spreading it over the five year period in any combination you prefer. This may be preferable if you anticipate a variable cash flow stream, and wish to distribute more during years of lower income.
Finally, if the account is substantial, you may wish to choose the lifetime distribution option. This choice allows you to compute and receive an amount each year based upon the account value and your life expectancy that theoretically depletes the account by the date of your death. If you do not need the money or are tax-sensitive, this option stretches out the distributions (and the tax burden) over your lifetime. Uncle Sam must be patient.
There are a few other wrinkles. If the original owner was over the age of 70 1/2, a required minimum distribution must be taken each year, including the year of death. You will be responsible for paying the distribution for the current year if it has not yet been satisfied.
Also, inherited IRA accounts are not subject to rollover rules. With a traditional IRA you may withdraw funds once per year and re-deposit them within 60 days without tax or penalty. Not so for an inherited IRA.
Chances are that you may find yourself the beneficiary of such an account one day. Be sure to do it right in order to avoid costly errors.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett and Co. in Chattanooga.