By FPA member Eric S. Toya, CFP®
Last Updated: October 25, 2010
For many, learning that you are the beneficiary of an inheritance of any size brings on a set of mixed emotions. The assets that you are about to receive are a welcome and appreciated addition to your household finances. Of course, the inheritance comes at the loss of a loved one, which may bring on feelings of guilt, sadness or a desire to treat the inherited funds differently as a way of honoring the deceased loved one.
If you are receiving an Individual Retirement Account (IRA) as part of an inheritance, it is particularly important to understand that there are some specific rules that govern how you may receive and take ownership of the funds. If you handle the process properly, you can continue to defer taxes, possibly for many years. If you mishandle the process, you may cause the entire amount to be taxed immediately.
There are two different sets of rules for spousal beneficiaries and for all other beneficiaries. Simply put, the spousal beneficiary has far more options available. If you are inheriting an IRA from your spouse and you are the sole beneficiary, you have the option of treating the IRA as your own. You can do that in one of two ways. First, you can designate yourself as the account owner on the IRA that is being inherited. Second, you can roll the IRA over into another IRA already in your name, commingling with any existing funds. In both cases, the IRA simply continues in your name, and all usual rules around IRAs such as distribution penalties before age 59 1/2 and distribution requirements after age 70 1/2 still apply.
If you are inheriting an IRA from someone who was not your spouse (such as a parent or other relative), the rules are much more complicated. Unlike a spousal beneficiary, you cannot treat the IRA as your own. This means that you cannot simply change the title of the existing account to your name, or do a rollover of any sort into or out of the inherited IRA.
In order to take ownership of the funds, you will want to open an Inherited IRA. You can do this with the current custodian (typically brokerage firm or bank) of the IRA. The custodian will require certain documents, such as a death certificate, your identification and the signing of their internal forms.
This next point is extremely important. Do not have the custodian distribute the funds in the form of a check made payable to your name, or transfer the funds into an account in your name. Some make this mistake thinking that they have 60 days to deposit the funds in a properly titled IRA. The process that they are thinking of is called a “60 Day Rollover” and applies for your own IRA monies. But remember, an Inherited IRA is not eligible for a rollover of any type. As soon as the custodian cuts that check or puts the money directly in your name, the entire account is now taxable.
Properly handled, an Inherited IRA may be distributed over the remaining years of your life expectancy, spreading out the tax liability over many years. Inherited IRA distribution rules are complex, and you should seek the advice of a financial planner to guide you through the process.
FPA member Eric S. Toya, CFP®, is a vice president with Trovena, LLC.