Americans hold over $8 trillion in Individual Retirement Account (IRA) assets, a figure that continues to grow. Over time, it’s expected a meaningful portion of these funds will transfer to children, grandchildren, nieces and nephews, siblings, and even friends through inheritance.
But did you know that the rules are much different (and often more complex and confusing) when it comes to inheriting an IRA for those who are “non-spouses” of the deceased versus spouses?
It is not an uncommon scenario for a beneficiary to first learn of their IRA inheritance upon the passing of their loved one, so they are often not prepared for what lies ahead. Moreover, one wrong decision with an inherited IRA can lead to significant negative financial consequences, such as paying unnecessary taxes and penalties, or forfeited future growth. Experts caution that persuading the IRS to give an inexperienced or wronged beneficiary a tax “do-over” is merely wishful thinking.
So here are six pitfalls all non-spouses should remember when inheriting an IRA:
- Do not violate commingling rules: Unlike spouses, non-spouses cannot rollover their inherited IRA assets into an existing IRA. A separate inherited IRA account must be created and it cannot accept additions. Violation of this rule can subject you to possible taxation and penalties.
- Understand the power of “Stretch”: As a non-spouse beneficiary you have two options for making distributions:
- Maintain the funds in the IRA for as long as possible by taking distributions over your life expectancy. To use your life expectancy, you must establish an Inherited IRA (see titling rules in #3 below) by December 31st in the year after the original owner’s death; or
- Use the 5-year rule that requires you to fully liquidate the account five calendar years after the year of the original owner's death.
The stretch option is powerful because it enables you to grow your inherited assets tax-deferred for potentially decades. However, you put this option at risk if you do not strictly adhere to all of the Beneficiary IRA rules.
If there are multiple heirs, you will have maximum flexibility by carving out your own Beneficiary IRA and utilizing your single life expectancy for withdrawals. If no carve-out occurs, the oldest beneficiary’s life expectancy will drive your distribution schedule and could result in your distributions occurring at a faster rate than would otherwise occur.
- Be sure to correctly title the IRA: The title of the IRA will govern the rules for distribution and taxation. To maintain tax-deferred status of the funds, be vigilant that the custodian or advisor complies with IRS naming rules, which require maintaining the deceased IRA owner's name on the inherited IRA account title and indicating in the title that it is an inherited IRA using words like “beneficiary” or “inherited IRA.” If the IRA account is not titled properly, the newly established account could be subject to tax and penalty.
- Know when mandatory distributions are required: No matter your age, you must take a “required mandatory distribution” (or RMD) from your inherited IRA. The 10% penalty on IRA withdrawals before age 59-1/2 is not applicable to inherited IRAs. If you do not meet the distribution requirement in full or part in any of the following scenarios, the IRS assesses a 50% penalty on the shortfall.
- If the original IRA owner did not take their RMD in the year of death, then the beneficiary must take the RMD amount by December 31st of that year.
- If the deceased owner had met their year of death RMD, the beneficiary must take their first mandatory distribution by December 31st in the year after the IRA owner died.
- If the original owner was not yet subject to an RMD, then the beneficiary owner is required to begin taking distributions in the year after the owner’s death based on either the 5-year rule or the stretch rule (described in #2 above).
Missing a distribution may subject you to a default distribution provision in the IRA agreement. Some agreements will require full distribution of the account in 5 years.
- Be aware there is no 60-day Rollover: Standard IRA rules allow for a tax-free “60-day rollover” where an IRA owner can take a tax-free distribution from one IRA account once in a 12-month period, as long as all the funds are redeposited within 60 days. However, inherited IRAs are not eligible for the 60-day rollover. Any funds withdrawn from an inherited IRA cannot be redeposited and will be taxed.
- Understand the exposure to Creditors: Federal law protects standard IRA accounts from claims of creditors when the owner files for bankruptcy. The intent is to help bankrupt individuals with a fresh start. However, per a 2014 Supreme Court ruling, Beneficiary IRAs owned by non-spouses are not exempt from bankruptcy claims because the inherited IRA assets do not constitute retirement funds.
Inherited IRAs are fraught with complexity, and some custodians are more well-versed than others in this area. Mistakes do occur. Before you act on your IRA inheritance, be sure to engage a financial advisor or other professional with a proven track record in managing Beneficiary IRAs.