Q: As many of us have parents getting older, could you please inform us about how to best handle an IRA which you receive as a beneficiary upon their passing? I am sure the rules are tricky and one mistake could lead to unitended taxable income.
Richard, North Providence RI
A: The rules on this are pretty tricky, which is why you should always be careful how you do it. Let's dig in and get our hands dirty...
The first place to look for any of these questions is IRS Publication 590, Individual Retirement Arrangements.
If you need to learn more about IRAs, click here to read my piece on it.
- If you inherit an IRA from your spouse, you can treat it as your own. This could mean putting it in your own name, or rolling it into another IRA or workplace retirement plan
- If you inherit an IRA from someone other than your spouse, you cannot treat it as your own. At this point, you could either cash out the IRA (and pay taxes on the distribution), or elect to "stretch" the IRA distributions over your lifetime. In order to do this latter option (which is almost always a good idea), you must be the primary beneficiary, you must do a trustee-to-trustee rollover into the stretch IRA, and the IRA must be maintained in the name of the decedent for the benefit of the beneficiary
Let's talk about that latter option a bit more. It's almost always better, for example, if a 40 year-old can stretch his parent's $500,000 IRA over his own lifetime, rather than paying tax on that money all in the first year.
How long could he stretch out the distributions? According to the IRS, our 40 year-old is expected to live another 43.6 years. This would mean that his first annual distribution would be 1/43.6, or $11,468. The second year would be 1/42.6, the third would be 1/41.6, and so on. Even better, he can wait until the year after the decedent's death to make his first distribution.
In order to get to this IRA-nirvana, he must be listed as the primary beneficiary. He must do a trustee-to-trustee transfer of the IRA, and the IRA must be maintained in the name of the decedent for the benefit of the beneficiary. So, the account might be named, "IRA of John Smith FBO John Smith Jr."
If there is more than one beneficiary listed by September 30th of the year following the date of the decedent's death, the beneficiary with the shortest life expectancy will be the designated beneficiary for these purposes. The only exception to this is if the IRA had been divided into separate accounts or shares.
If an IRA has named a trust as the beneficiary, the stretch ability might be lost. There are some complicated rules to follow to keep the stretch for the trust beneficiaries.
Since Roth IRA distributions (if qualified) are free of tax, there are usually no tax implications to Roth IRA beneficiaries. Spouses can treat a Roth IRA as their own, or delay the required minimum distributions until the decedent would have turned 70.5. Non-spouse beneficiaries can either cash out or do the stretch.
Why bother with the stretch if you don't have to pay taxes on distributions? Simple--buildup of Roth money is tax-free. By foregoing the stretch here, you're also foregoing the tax-deferred growth of the money.
There is one minor exception when Roth IRA distributions would have to be taxed: if the decedent first made a Roth IRA contribution less than five years prior to death, the earnings on the Roth IRA are taxable.
Qualified Plans, SEPs, SIMPLEs
What if you inherit assets from a 401(k) or other type of defined contribution workplace retirement plan? The rules on this changed with the passage of the Pension Protection Act in 2006. Under prior law, 401(k)s were simply cashed out to the beneficiary, who then paid tax. The only exception was for spouses, who could do a "stretch" payment. That option is now available to any beneficiary.
SEP-IRAs inherited by people are treated the same as if they were Traditional IRAs for inheritability purposes, as are SIMPLE plans.