By Liz Farr, CPA
September 5, 2017
Over the next few decades, the Gen X and Millennial generations will be the recipients of one of the greatest wealth transfers in history. A portion of that will be in the form of IRAs from their parents, grandparents, and other relatives.
An inherited individual retirement account (IRA) can be a tremendous boon to the beneficiary. “Who can’t use extra money in retirement?” asked Joe Cannova, CPA, owner of Joseph A. Cannova CPA CFP, an accounting and financial planning firm in Toms River, N.J. Depending on the relationship between the decedent and the beneficiary, an inherited IRA may come as a complete surprise to the beneficiary.
According to Rebecca Walser, J.D., LL.M., a tax attorney and founder of Walser Wealth, a wealth management advisory in Tampa, Fla., most inherited IRAs are cashed out within six months after the family member dies. “Sometimes people will come to you with the funds after they’ve been cashed out. Then there’s no tax strategy there because that’s it, they’ve cashed it out.”
Without proper planning, federal and state taxes can take a sizable bite out of the proceeds. The IRS has special rules that must be followed.
Options for inherited IRAs
There are several options for traditional non-spousal inherited IRAs, depending on the decedent’s age. (This article does not address spousal IRAs. A spouse who inherits an IRA can treat it as his or her own.) An account owner over age 70½ is required to begin receiving required minimum distributions (RMDs) from the account by April 1 of the year after he or she reaches age 70½ (the required beginning date). If the decedent had already passed the required beginning date, there are just two choices:
- Taking a lump-sum distribution of the entire balance; or
- Rolling the inherited IRA over into a new account and taking distributions over the longer of the life expectancy of the beneficiary or of the decedent.
If the account owner died before reaching the required beginning date, the beneficiary has a third option of withdrawing all of the funds in the IRA account by the end of the year containing the fifth anniversary of the decedent’s death under the five-year rule. In addition, under the second option, the life expectancy of the beneficiary must be used.
If the inherited IRA was a Roth IRA, the RMD rules for decedents who died before reaching the required beginning date apply.
To make sure you choose the best option for your situation, here are tips to consider:
Keep the beneficiary designations up to date.
Divorce, marriage, and the birth of children can all change estate plans. “A lot of people don’t realize that an IRA passes by beneficiary designation as opposed to will,” Cannova said. “If the will says I leave everything to my wife, but they have a different beneficiary designation on the IRA, it’s generally going to whoever is the beneficiary on the IRA paperwork.”
Make sure the new inherited IRA is titled correctly.
An inherited IRA must be titled with both the name of the decedent and beneficiary plus the word “inherited.” Here’s an example of correct titling: “Jane Doe, deceased (insert the date of death), F/B/O (for benefit of) Jimmy Doe, beneficiary.” Cannova said he’s seen many cases where the beneficiary has called the brokerage and asked that the IRA be transferred to his or her name. “If you just change the names on that IRA, that’s really a cash-out.” That means that putting the IRA in only the beneficiary’s name will cause it to be treated as a distribution of the entire balance in the IRA subject to taxes. Retitling the account is best done at the brokerage where the decedent held the IRA before the beneficiary rolls it over to his or her own brokerage.
Check that the decedent took any required RMDs in the year of death.
This is one of the biggest traps that Cannova sees when the decedent was over 70½ and died before taking the annual distribution. “You must take their required minimum distribution before the end of the year, or else there’s a 50% penalty, and you still have to take the distribution.”
Pay attention to statutory deadlines.
Under the life-expectancy method, the first RMD must be taken by Dec. 31 of the year after the decedent’s death. This is also the deadline for electing to use the five-year method if the decedent was not yet taking distributions.
Converting an inherited IRA into a Roth may save tax over the long term.
It is important to consider your age, current income, and existing retirement and investment accounts. If it appears that you already have ample resources to fund retirement, Walser recommends converting all or part into a Roth IRA to take advantage of today’s historically low tax rates.
You will pay tax on the Roth IRA when the funds are rolled over, but the account then grows tax-free, and any distributions will also be tax-free if it has been at least five years from the beginning of the year you first set up and contributed to a Roth IRA and you have reached age 59½. The original amounts contributed to the Roth IRA can be withdrawn without paying tax at any time because the funds have already been taxed.
If you have other pre-tax sources of retirement income, you should also consider converting them to a Roth IRA.
Performing an analysis under different scenarios can provide useful guidance to help you make the best decision.
If you have few resources for retirement, Cannova noted that there may be no long-term benefit to rolling the balance into a Roth IRA. If your only retirement income will be Social Security and the inherited IRA, “even if it was a taxable IRA, there’d be no taxes because their income is so low. You’d have to crunch the numbers to see if that makes sense.”
Your Social Security benefits would have to be very low, however, for this to work because the money from a taxable IRA could cause part of the client’s Social Security benefits to be taxable. For an unmarried taxpayer, if “provisional income,” which is gross income (not including a person’s Social Security benefits) with certain modifications plus 50% of the person’s Social Security benefits, is above $25,000, up to 50% of the person’s Social Security benefits will be taxable (if it is above $34,000, up to 85% is taxable).
In these situations, if you have a low enough income to avoid paying tax on Social Security benefits, an inherited IRA can make a big difference to the beneficiary’s retirement income.
Consider the impact of possible future tax increases.
Even if taking a full distribution at once or over five years means a substantial tax bill now, it may well save taxes in the long run if tax rates increase in the future. If your main sources of retirement income are in pretax accounts, increases to tax rates can be catastrophic.
Liz Farr, CPA is a freelance writer based in Los Lunas, N.M. To comment on this article, contact Chris Baysden, senior manager of newsletters at the AICPA.