Content provided courtesy of USAA
If you've inherited an IRA, you'll have some important decisions to make and strict deadlines for making them. Making the wrong choice or dragging your feet could trigger a big tax bill, so it's important to understand the rules.
"Many people don't understand the rules, and think they have to simply cash out right away," says Scott Halliwell, a CERTIFIED FINANCIAL PLANNER™ practitioner with USAA. "They don't realize they have an option to keep it in a retirement account and don't understand the benefits of doing so."
When you inherit an IRA, you'll ultimately be responsible for paying the taxes that the owner had deferred. If you cash out in a lump sum, you'll owe all those income taxes at once. If that extra shot of taxable income is big enough, it could even bump you into a higher tax bracket and cause you to lose tax benefits that aren't allowed for "high-income" taxpayers.
By keeping as much money inside an IRA as long as possible, you can spread out your tax bill over time and give your inherited money an opportunity for continued tax-sheltered growth.
Just how long depends on whether the previous IRA owner had already started taking required minimum distributions, which begin at age 70½.
If those required distributions hadn't started yet, you can take annual payments that spread the drawdown of the account over your remaining life expectancy, using an IRS table. If they had already started, you can spread it over your life expectancy or the previous owner's, whichever is longer.
What if there are multiple beneficiaries? "In that case, unless separate accounts have been established, the IRS looks at the age of the oldest beneficiary," Halliwell says.
If you've inherited an IRA from your spouse, you can make it your own by rolling it over to a new IRA in your name or merging it with your own existing IRA. Doing so means you can make your own contributions to the account — something non-spouse beneficiaries can't do.
"While making the IRA your own may sound like the simplest option, it isn't always the best," Halliwell says. That's particularly true if the surviving spouse is under 59½. "By making it your own, you'll likely lose your ability to tap it before age 59½ without getting hit with a 10% tax penalty," Halliwell says.
If you inherit an IRA, mark this date on your calendar: Dec. 31 of the year following the year of the IRA owner's death.
"If you don't make a choice by then, then the IRS has already made your choice for you," Halliwell says. If you haven't elected another option by that date, you'll be forced to take everything out of the account by the end of the fifth year following the IRA owner's death.
One of the advantages of a Roth IRA is that rules for required minimum distributions don't apply to them. However, that feature doesn't carry over to the people who inherit them.
"As with a traditional IRA, non-spouse beneficiaries have to start taking money out," notes Gregg Rivas, USAA executive director of retirement solutions. "Generally, as long as assets have been in the Roth IRA for five or more years, beneficiary Roth IRA distributions are tax-free."
No matter what's in someone's will, the beneficiary designation on an IRA determines who gets it. If no beneficiary was named, you still may end up inheriting the account after it goes through probate, but you'll lose the ability to spread the money over your life expectancy. You'll generally have to exhaust the account over five years or, if required minimum distributions already had started, over the deceased owner's life expectancy.
If you're concerned about your beneficiaries making smart decisions — or want to have more control over how payouts are made over time — consider a trusteed IRA.
"It not only gives you the ability to control your legacy after you've died, it also lets you benefit from professional investment management of the account while you're living," Rivas says.
For more on the rules for inherited IRAs, see IRS Publication 590. For personal guidance from a licensed USAA advisor, call 1-800-472-USAA.