If you inherit an IRA, what you do next determines how much tax you will owe on your inheritance. Make a mistake and the entire IRA balance becomes taxable. In addition to owing Federal income taxes on the inherited IRA, you may also owe state income tax and possibly even estate taxes when you inherit an IRA from someone other than a spouse.
Tally it all up and half or more of the IRA could end up going to the IRS.
The average IRA balance varies by age, but for people over age 65 the average balance exceeds $212,000. In many cases IRAs can exceed $1 million or more during the IRA owner’s lifetime. A wrong move by the beneficiary could result in a gut-wrenching six-figure tax bill.
When you inherit an IRA, follow these three steps to avoid a tax disaster.
First, do nothing. You have at least a year or more to consider your options and decide what you want to do with an inherited IRA.
As a “non-spouse beneficiary” on an inherited IRA the IRS requires you to begin taking a minimum distribution by December 31 of the year AFTER the year the original IRA owner died. If your mother died in 2016 and left you her IRA, you will need to take the Required Minimum Distribution (aka RMD) by the end of 2017.
The IRA custodian may try to encourage you to get this done quickly, but this is not the type of decision you should rush through or one that needs to be made right away. Talk to your financial advisor or tax professional to review your options and be sure you are setting up your new IRA correctly.
Second, establish a properly titled inherited IRA. Even if you wish to spend the proceeds from the inherited IRA, you will need to set up your own inherited IRA first. Once the inherited IRA is established you are free to do what you like.
This new IRA must be separate from your traditional IRA and other retirement accounts.
Typically, you would set up the new, inherited IRA with a registration similar to the “Jane Doe inherited IRA FBO (your name)”. Different IRA custodians may use slightly different language, but the key is that the inherited IRA contains the name of the deceased IRA owner and is clearly identifiable as an inherited or beneficiary IRA. The reason has to do with the required minimum distributions, more about that below.
When you set up your new, inherited IRA don’t forget to establish new beneficiaries as well. Missing this important step could cause the entire IRA you inherited to become taxable when you pass it on to your beneficiary.
Third, take your RMDs. The IRS requires that those who inherit IRAs take a minimum taxable distribution each year, also known as your Required Minimum Distribution or RMD.
Distributions from the inherited IRA are taxable, but they are free from penalties. Of course, you may take out more than the RMD, but every year you will need to take out at least the RMD amount from your IRA. Failure to do so can result in a penalty of 50% of the RMD amount.
The RMD is based on the value of the account at the end of the year and your age. Every year it must be recalculated. Savvy owners of inherited IRAs who take only the RMD each year can defer taxes long into the future, allowing the IRA to become a source of income that may continue to grow for many years to come.
One chance to get it right
IRAs and IRA distribution planning can be complicated and the stakes are high, especially with larger IRA balances. The taxable income you receive from the IRA will effect your tax bracket, financial aid for college, taxation of social security benefits, how much you pay for health insurance and Medicare, etc.
Unfortunately a mistake on an inherited cannot be undone. You have one chance to get it right.
Making a mistake on a $10,000 IRA is one thing. Making a mistake on a $1 million IRA is, well, we just don’t want to go there. In the words of IRA expert Ed Slott, “If you mess up your mother’s IRA, that’s OK. Now you know how to get it right the next time you inherit an IRA from her”. FYI, there is no “next time”.
Join me next week when I share the one key decision everyone must make when they inherit an IRA from their husband or wife.