When you are named the beneficiary of an IRA and the IRA owner dies, you may think you’ve received a tax-free inheritance. You’re only partially correct. Under tax law, the receipt of the inheritance is tax-free, but you are required to take distributions, which are probably taxable (taxation depends on the type of IRA involved).
You Inherit an IRA: What Happens Next
When you inherit an IRA, you are free to take as much of the account as you want at any time as long as you satisfy the required minimum distribution (RMD) rules discussed below; you can take a distribution of all the funds at once if you prefer. If the IRA is a traditional IRA to which all contributions were tax deductible, you’ll pay income tax on the amount distributed, but there’s no early distribution penalty even if you and/or the owner is under age 59½ If you inherit a traditional IRA to which both deductible and nondeductible contributions were made, part of each distribution is taxable.
If you inherit a Roth IRA, it is completely tax free if the owner held any Roth IRA for at least five years (starting January 1 of the year in which the first Roth IRA contribution was made). If you receive distributions from the Roth IRA before the end of the five-year holding period, they are tax free to the extent they are a recovery of the owner’s contributions and taxable to the extent they are allocable to earnings.
Regardless of the type of IRA you inherit, you must take at least a minimum annual amount over a certain period; these distributions are called required minimum distributions (RMDs). If you fail to, you can be subject to a whopping 50% penalty on the amount that should have been withdrawn. (For more on RMDs, see An Overview of Retirement Plan RMDs and Preparing for Retirement Plan RMD Season.)
RMDs are designed to eventually exhaust the funds in the account so that tax-deferred, or in the case of Roth IRAs, tax-free, accumulations won’t last forever. There are two RMD methods:
You can postpone any distributions as long as you empty the account by the end of the fifth year of death (called the five-year rule). For example, a parent dies in April 2018, leaving an IRA to her daughter. If she uses this method, all of the funds must be withdrawn by December 31, 2023.
You take RMDs over life expectancy. Use your own life expectancy if the original IRA owner was not at least 70½ and taking RMDs. This means applying the life expectancy for your age found in the Single Life Expectancy Table (Table I in the Appendix B of IRS Publication 590-B). If the owner was already taking RMDs (i.e., was at least 70½), use the longer of your single life expectancy or the owner’s life expectancy based on the owner’s age on the birthday in year of death). Thus, if you inherit an IRA from your younger sister, using her life expectancy produces smaller RMDs (remember that you can always take larger distributions if you want the funds).
“Clients overwhelmingly choose to convert to an Inherited IRA and take life expectancy payments,” says retirement-planning expert Stephen Rischall, co-founder of 1080 Financial Group in Sherman Oaks, Calif. ” I’ve had fewer than 10% of beneficiaries choose lump sum, and never had a client choose the five-year option.”
The RMD rules for beneficiaries do not eliminate the need for the deceased owner’s estate to take his or her RMD for the year of death if the owner died on or after attaining age 70½. The RMD for the owner reduces the account value on which the RMD for the beneficiary is figured. Let’s suppose the IRA holder, we’ll call him Tom, dies in 2018. If Tom was required to take a required minimum distribution (RMD) for 2018 (and did not do so before he died), his beneficiaries are required to withdraw that amount by December 31, 2018. The payer is required to report the amount under the beneficiary’s tax identification number, and the beneficiary is required to include the amount in his or her income. Bear in mind also that the amount is calculated as if the IRA owner (Tom) had been alive for all of 2018.
Caution: When you inherit an IRA, make sure that the title to the account conforms to tax law. If you are a non-spouse beneficiary, do not put the account in your own name. The account title should read: “[Owner’s name], deceased [date of death], IRA FBO [your name], Beneficiary” (FBO means for “the benefit of”). If you put the account in your name, this is treated as a distribution, and all of the funds are immediately reported; it’s very difficult to undo this error.
Special Rules for Surviving Spouses
If you are the surviving spouse of an IRA owner and are the sole beneficiary of the IRA, you have a choice.
You can act like any other beneficiary, as explained earlier. However, if your spouse died before the year of his or her 70½ birthday, you do not have to start receiving RMDs until that year. “If your deceased spouse was younger, choosing an inherited IRA may be beneficial because it delays RMDs to when the younger deceased spouse would have turned 70½,” says Rischall.
You can treat the account as your own by naming yourself as the account owner or by rolling over the IRA to your own account. This enables you to make contributions to the account if you are eligible (e.g., you have earned income, are under age 70½), to name your own beneficiaries and to postpone RMDs until you reach age 70½. This is a good choice if your spouse was older than you are because it delays the RMDs.
This is not an all-or-nothing decision. You can parse the account and roll over some of it to your own IRA and leave the balance in the account you inherited. However, there’s no changing your mind. If you make a rollover and need funds from it before age 59½, you’ll be subject to the 10% penalty (unless some penalty exception other than death applies).
Special IRA Transfer Rule
If you are age 70½, you can transfer up to $100,000 from an IRA directly to a qualified charity. The transfer, which is called a qualified charitable distribution even though no tax deduction is allowed, is tax-free and can include RMDs (i.e., they become non-taxed). This tax break was made permanent by the Consolidated Appropriations Act of 2016, which became law on December 18, 2015.
Handling Tax Issues
When taking RMDs from a traditional IRA, you’ll have income taxes to report. You’ll receive Form 1099-R showing the amount of the distribution. This is reported on Form 1040 or 1040A; if you receive a distribution, you cannot use Form 1040EZ even though you might otherwise eligible be to do so.
If the distribution is sizable, you may need to adjust your wage withholding or estimated taxes to account for the tax that you’ll owe on the RMDs. These distributions, which are called nonperiodic payments, are subject to an automatic 10% withholding unless you opt for no withholding by filing Form W-4P.
If the IRA owner died with a large estate on which federal estate taxes were paid, as the beneficiary you are entitled to a tax deduction for the share of these taxes allocable to the IRA. The federal income tax deduction for federal estate tax on income in respect of a decedent (such as an IRA) is a miscellaneous itemized deduction (you can’t claim it if you use the standard deduction instead of itemizing), but is it not subject to the 2%-of-adjusted-gross-income threshold applicable to most other miscellaneous itemized deductions.
The Bottom Line
Inheriting an IRA is a blessing and a curse. You obtain an asset that cost you nothing, and the asset can continue to grow. However, you face a tax bill if the asset is a taxable IRA. You cannot avoid this because the law requires you to take RMDs or face a 50% penalty. Check with the custodian or trustee of the IRA for the amount and timing of your RMDs. Also, work with a knowledgeable tax advisor to ensure that you meet RMD requirements.