If a loved one has passed away and made you a beneficiary of an IRA, hold on to your hat, because the IRS has laid out a tightrope for you to walk, where one misstep can lead to 50% penalties and lost tax savings. If at any time you are unsure about what needs to be done, please seek immediate expert counsel because many mistakes, once made, cannot be undone. With that said, here are the steps you need to take to maximize the tax-deferred benefits of an inherited IRA.
Do you want the money to go to someone else?
By disclaiming the IRA, a primary beneficiary can redirect the IRA to the remaining primary beneficiaries or to the contingent beneficiaries if no primary beneficiaries remain. The decision to disclaim should be made as soon as possible, but it must be made within nine months of the IRA owner's death. If disclaiming is a consideration, please consult an estate-planning professional as this can have significant estate tax consequences.
Do you need to take a distribution for the original IRA owner?
If the IRA owner died after his or her required "beginning date" (April 1 of the year after the owner turned 70 1/2), and had not taken the required minimum distribution (RMD) for the year, then the beneficiary must take this distribution by December 31 of the year the IRA owner died.
To calculate the RMD, look up the owner's distribution period in the Uniform Lifetime Table using the age the owner would have attained by December 31 in the year he or she died. Then divide the IRA's value on December 31 of the previous year by the owner's distribution period.
Are you a surviving spouse?
Surviving spouse beneficiaries have the option of treating the inherited IRA as their own, in which case the normal IRA rules for owners apply and the remaining steps in this article may be ignored. Spouses usually make this choice because it often provides greater flexibility (e.g., can change beneficiaries), simplicity, and tax deferment. However, when the surviving spouse is older than the IRA owner, or is under the age of 59 1/2 and needs immediate access to some or all of the money, it may make more sense for the spouse to decide to be treated as a beneficiary rather than becoming the new owner of the IRA.
Are you part of a crowd?
When you are one of several beneficiaries of an IRA, the IRA should be split into separate accounts by December 31 of the year after the IRA owner's death, creating one account for each beneficiary. This will allow each account to use its beneficiary's life expectancy when calculating required distributions; otherwise, the oldest beneficiary's age is used to calculate the required distributions for all beneficiaries.
How do you calculate the required minimum distributions?
RMDs are calculated by dividing the IRA's value on December 31 of the previous year by the appropriate distribution period.
Spouse beneficiary : When a spouse decides to be treated as a beneficiary rather than an owner, there are no RMDs until the year the IRA owner would have reached age 70 1/2, or the year following the owner's death, whichever is later. When RMDs commence, the distribution period is determined by the Single Lifetime Table using the age of the spouse in the current year. Each year thereafter, the new distribution period is determined from the table using the spouse's age.
Non-spouse individual beneficiary: In the year following the IRA owner's death, the distribution period is determined by the Single Lifetime Table using the age of the beneficiary in the year after the IRA owner died. Each year thereafter, the distribution period gets reduced by one.
Any beneficiary: This method may be used by any beneficiary, but must be used by non-individual beneficiaries (e.g., charity, estate). If the owner died after his or her required beginning date, then the distribution period for the year after the owner's death is the owner's distribution period when he or she died reduced by one, and then reduced by one each year thereafter. Otherwise, the beneficiary must distribute all funds from the IRA within five years after the IRA owner's death.
If you miss a required minimum distribution, the IRS will assess a 50% excise tax on the amount that was required to be withdrawn.
All transfers should be performed using direct trustee-to-trustee transfers. If the account title is modified to reflect only the beneficiary's name, or the beneficiary gets a check in his or her name, it is treated as an immediate distribution. All income taxes will be owed that year, and there is no way to put it back unless you are the surviving spouse and are rolling the money into your own IRA.
If the beneficiary is a trust, a copy of the trust documents must be delivered to the IRA custodian by October 31 of the year following the IRA owner's death with the provision that if the trust instrument is amended, the custodian will be provided with a copy of the amendment within a reasonable time.
Income taxes on distributions
In most cases, distributions are fully taxable as income to beneficiaries. However, there are two situations that, if they apply, can provide tremendous tax savings to the beneficiary.
The first occurs when non-deductible contributions were made by the owner of the IRA. Unfortunately, the only way to know the basis (the total non-deductible contributions made) for an IRA is from the owner's records. When an IRA has a basis, the ratio of the basis to the total account value determines the percentage of a distribution that is considered a return of basis instead of income.
The second deduction applies when estate taxes were paid due to the inclusion of the IRA in the estate. This deduction is called the income in respect of the decedent (IRD) deduction. To determine the total deductible amount, calculate the estate tax excluding the IRA and compare it with the estate tax including the IRA. The difference in estate taxes between these scenarios is the amount that the beneficiary could deduct if they withdrew all the funds out of the IRA. This total is then divided by the value of the IRA at the owner's death to provide the IRD deduction percentage. This percentage is then applied to each year's distributions to determine the amount of the IRD deduction until the full amount has been utilized. The deduction is made on the beneficiary's Schedule A as a miscellaneous itemized deduction not subject to the 2% floor or alternative minimum tax.
The above information is only a starting point. You should seek professional advice tailored to your individual circumstances. As is the case with most tax and legal matters, individual facts or circumstances may alter the application of the above rules or may involve other legal and tax considerations not mentioned here.