By FPA member and former CPA, Michael Cooper, CFP®, ChFC®
Last Updated: April 19, 2010
Inherited Individual Retirement Accounts (IRAs) are a relatively new and misunderstood topic, and thus many individuals make common mistakes when inheriting an IRA from a non-spouse individual (i.e. father, mother, brother, etc). One of the most common mistakes is the assumption that the non-spouse beneficiary can move the IRA into his or her own IRA.
If handled correctly, an inherited traditional IRA can be a cash windfall. But if you don't follow Internal Revenue Service (IRS) regulations to a "T," you could end up paying big penalties and income taxes. A spouse who inherits an IRA is the only person who can co-mingle funds with their own IRAs. Everyone else must keep inherited IRAs totally separate, and may not make new contributions to these accounts.
Below are several basic rules for inheriting a non-spouse IRA, and how to stretch the IRA account balance over many years:
- Make sure you name your IRA beneficiaries and update them every few years. The beneficiary form on an IRA is the first and most important part of receiving an inherited IRA. If you fail to name a beneficiary on your IRA, it is highly unlikely that your beneficiaries will be able to stretch the balance over many years. The designated beneficiates on your IRA form supersede the instructions of your will.
- Inherited IRAs cannot be commingled with other types of IRA assets. If you inherit multiple IRAs from the same person you can combine those IRAs into one inherited IRA. However, you cannot combine assets inherited from different individuals. In addition, you cannot combine inherited IRAs of different types. For example, you cannot combine a traditional non-spouse inherited IRA and a non-spouse inherited Roth IRA, even if they were both inherited from the same person. Examples of acceptable non spouse IRA titles, by IRS standards, include the following: "IRA FBO John Doe as beneficiary of Tom Doe" and "IRA FBO John Doe (Dec'd); Tom Doe (beneficiary)."
- Distributions from non-spouse inherited IRAs are not subject to the 10 percent penalty. Distributions from non-spouse inherited IRAs are not subject to the 10 percent early distribution penalty, regardless of the age of the beneficiary at the time the distribution occurs. The IRA custodian or trustee should code or flag the inherited IRA so that distributions are reported as "death distributions" with a code 4 in Box 7 of IRS Form 1099-R.
- Your IRA doesn't always allow what the IRS will actually allow. The tax code and IRS regulations allow the beneficiary two sets of distribution options for non-spouse inherited IRAs: 1) If the IRA owner dies before the required beginning date (RBD), the beneficiary can distribute the assets within five years of the owner's death, or over the beneficiary's single life expectancy or 2) If the IRA owner dies on or after the RBD, the beneficiary can distribute the assets over the longer of the remaining life expectancy of the decedent or the life expectancy of the beneficiary.
- Stretch that IRA over a lifetime, and create a legacy. Once you have your non-spouse inherited IRA in a properly titled account, you should use the single life expectancy payout if at all possible. That payout option will let you stretch the distributions from the inherited IRA over your lifetime. Read the rules about distributions in IRS Publication 590 on the IRS Web site. If the original IRA owner was required to take a distribution in the year of death and didn't, then the beneficiary must take it.
- No 60-day rollover. It's likely you've heard about 60-day rollover rule for IRAs. With this rule, you can take a distribution from your IRA and as long as you put the money back in the account within 60 days, you won't have to pay income taxes or a penalty. Some use this rule as a way to fund expenses in anticipation of getting cash within the 60-day period. Unfortunately, you can't do this with inherited IRAs. There is no 60-day rollover rule for inherited IRAs. If you withdraw the money, it's taxed.
- Seek the advice of a qualified financial professional. When it comes to inherited IRAs, there's a very good chance that the information you're getting from the IRA custodian could be incorrect. Be sure to get help from a qualified financial professional.
FPA member Michael Cooper, CFP®, ChFC®, is a former CPA and practices as a fee based father and son financial planning team with over 60 years of combined experience. Michael is a member of the Michael Cooper Group with Morgan Stanley Smith Barney, located in New York City and works primarily with retired, soon to be retired individuals, small business owners and independent women.