While it’s important for investors to determine who will assume an individual retirement account (IRA) upon their death, it can be equally as important for those inheriting an IRA to understand what to do with the money – including how to avoid costly mistakes.
Here are a few tips for those who are beneficiaries of IRAs, sorted by spouse and non-spouse recipients:
Spouse Inheriting an IRA
When a spouse is named as a beneficiary on a traditional IRA account, the easiest way to handle the transfer of money without it being taxed is to retitle the IRA and put it in his or her own name. This allows the beneficiary to keep the tax-deferred status. When the beneficiary reaches the age of 70-1/2, he or she must take the required minimum distributions (RMDs).
Where a spouse can misstep is forgetting to retitle the IRA in his or her own name, and taking the full lump sum all at once to pay for living expenses, which means the spouse has to pay taxes on the money right away. If he or she can defer the withdrawals over time instead of taking the lump sum, then the beneficiary avoids paying taxes on the entire amount, all at once.
Here’s where the situation gets a little trickier: If the beneficiary of a traditional IRA is a spouse younger than age 59-1/2, then there is also a 10 percent penalty for early withdrawal on top of the income tax. Young spouses who need some of the money can avoid the penalty by retitling the account as an inherited IRA, making sure to retitle the account again in his or her name alone at 59-1/2 years old to defer withdrawals until the required minimum distributions go into effect.
What if the account is a Roth IRA rather than a traditional setup? There is no tax penalty or income tax owed if you withdraw the money, since the tax is taken out when the money is contributed. However, you eliminate the opportunity to grow the existing funds, tax-free, in the future.
Non-Spouse Inheriting an IRA
If you are a non-spouse, such as a child or parent, who is the beneficiary of a traditional IRA account, then your options are not quite as simple. Particularly, the biggest difference is that you don’t have the liberty of rolling over the funds into your own name.
To take advantage of the ongoing tax-deferred gains, you should retitle the account as an inherited IRA. While the IRS will require that you take RMDs every year, starting right away, you can still reinvest the funds from the RMDs to continue growing your money. If you inherit a 401(k) instead of an IRA, then you can also retitle the account as an inherited IRA to protect the status of the funds.
Here’s where non-spouse beneficiaries make mistakes: If you decide to cash out the account, then you must pay income tax on the full amount and you lose the tax shelter that an IRA affords. This is a huge money fumble, because you lose money now and in the future.
Questions about inherited retirement accounts?
Guidant Wealth Advisors’ senior staff can explain the rules and provisions of assuming IRAs, 401(k) accounts, and other investments. Please contact us to discuss your options in managing and maximizing retirement funds.