As the population in the U.S. grows older, it is becoming increasingly common for individuals to inherit retirement accounts from their family members, or close friends. If you find yourself becoming a beneficiary who inherits such an account, it is important to you follow particular steps in order to avoid making costly mistakes.
There are several options to handling inherited accounts, which depend on a variety of factors including your relationship to the original account holder, the age of the original account holder when they passed away and the type of account you’ve inherited. Here are four crucial steps to follow to increase your benefits in the long run:
Step 1: Title the New IRA
Once you inherit an IRA, you’ll want to make sure it’s set up correctly. An inherited IRA should have the name of the deceased original owner and it should also indicate that the IRA was inherited. You'll likely need a copy of the decedent's death certificate available when opening the account. Alternatively, if the deceased was your spouse, you have the option to roll over the amount of the inherited IRA into your own individually titled IRA. Keep in mind that if you transfer any distributed money to a new account in your name, you must do so within 60 days.1
If you’ve inherited an IRA from someone other than a spouse, you will not be able to move money into your own retirement account. In order to keep the tax benefits of the inherited account, you will need to set up a new Inherited IRA for Benefit under your name.2 After the account has been created, you’ll be able to transfer assets from the original account into your beneficiary IRA.
Step 2: Calculating the Right Distribution Amount
If you’re a spouse of the deceased, you can either transfer the assets into your own IRA and treat it as your own, thereby delaying distributions until your reach Required Minimum Distribution (RMD) age of 72. You may also begin distributions using the life expectancy method of distributing over your lifetime, determined by the IRS life expectancy tables. Under the life expectancy method, the prior year-end account value and life expectancy are needed to calculate the distribution amount on your inherited IRA. For this calculation, the value of the account from the last year is used. For example, in order to calculate distributions for the year 2021, the account value on December 31, 2020, is used.
If you are a non-spousal beneficiary, it is very important to note that you’ll be required to withdraw the entirety of the account within 10 years, if the deceased passed on or after January 1, 2020.3 Prior to the SECURE Act passing, the IRA amount was allowed to be withdrawn throughout the beneficiary’s remaining life expectancy. You have the option to wait until year 10, or take distributions every year for the 10 years, or distribute the balance at any time before then.
Be sure you know the amount and timing of your RMD because a missed RMD may result in a 50% tax penalty4 on the missed amount!
Step 3: Determine If the IRA Has an After-Tax Basis
Most beneficiaries are either unaware or unwilling to find out if the IRA they’ve inherited has an after-tax basis. If you have inherited an IRA and you find out that it has an after-tax contribution you should fill out IRS Form 8606.5 By completing this form you’ll be able to claim the non-deductible portion of the required minimum distribution as a tax-free return of basis.
You can always ask the executor if they are aware that the IRA has an after-tax contribution, but they might not know themselves and will need to refer to the tax returns of the deceased to learn if they filled out the form previously.
Step 4: Make a Plan for the Taxation of Distributions
Taxation of distribution is different for Roth IRAs and other IRAs. In many cases, Roth IRAs have distributions that are tax-free if the beneficiary is taking the minimum distributions. However, for other IRAs, the distributions are fully taxable unless the original IRA owner had a tax basis on their IRA. If the distribution is taxable, you can add the taxable portion of the distribution to the tax projection for the year to learn the amount of tax you should withhold.
As you make a plan for distribution, remember the SECURE Act’s new change for non-spousal beneficiaries. You will be required to distribute the entirety of the account within 10 years of inheriting it. Exceptions to this rule include:
- Disabled or chronically ill persons
- Those who are less than 10 years younger than the deceased3
To avoid making costly errors, you should meet with a knowledgeable financial advisor and tax professional as soon as you learn that you may be inheriting an IRA. Mistakes could mean larger taxes and complexities in the long run.
Investment Advisory Services offered through EnRich Financial Partners LLC, a Registered Investment Advisor.
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