Make the Most of an IRA You Inherit

 In Investments, Retirement

If you inherit an IRA, you have several choices of what to do with it. The right choice can help you enjoy penalty-free distributions, tax-deferred accumulation, or possibly tax-free income. An inherited IRA falls into one of four categories. You may be the beneficiary of a Roth IRA or a traditional IRA. Also, you may inherit an IRA from your spouse or someone other than your spouse.

Traditional IRA, from spouse
A traditional IRA usually is funded with pretax dollars—money that was never subject to income tax. Therefore, you’ll probably owe income tax on some or all of the money you withdraw from a traditional IRA you inherit. You’ll pay tax on withdrawals at your ordinary income tax rate. You won’t owe a 10% penalty for early withdrawals, no matter how old you are, because the tax code provides IRA beneficiaries with an exception to this penalty.

If you don’t need the money right away, you can extend the tax deferral. Surviving spouses have a unique opportunity: they can roll over an inherited IRA to their own IRA.

Example 1: Kim Snyder, age 51, inherits an IRA from her husband Matt. Kim can retitle the IRA in her own name and designate her own beneficiaries. Because Kim is not yet age 70½, she can defer required minimum distributions (RMDs) until she reaches that age.

This strategy will work well if Kim does not need the money from Matt’s IRA now. She may let the account build for years, sheltered from income tax, until her RMDs begin. (Whenever RMDs begin, IRA beneficiaries owe a 50% penalty on insufficient distributions.)

However, suppose Kim needs the money in Matt’s IRA right away. If she rolls the inherited IRA to her own IRA, she probably would owe income tax plus a 10% early withdrawal penalty on any distributions before age 59½.

In this situation, Kim would be better off leaving the inherited IRA in Matt’s name. That way she can withdraw the cash she needs without paying the 10% early withdrawal penalty. Once Kim reaches age 59½ and the penalty is not a problem for her, she can roll the IRA to her own name and designate beneficiaries.

Roth IRA, from spouse
Suppose Kim inherits a Roth IRA instead of a traditional IRA from her husband. Again, as a surviving spouse she can roll this account into her own Roth IRA. Not only will doing so allow Kim to designate her own beneficiaries, she’ll be able to avoid RMDs as long as she lives. Although Kim must take RMDs from an inherited Roth IRA, a Roth IRA owner never has to take distributions from his or her own account. If Kim has ample assets, she can allow the Roth IRA she claims as her own to build indefinitely and untaxed—and eventually leave the account to her beneficiaries.

Is there a downside to rolling over a Roth IRA inherited from your spouse? Yes.

Example 2: Matt Snyder retires in 2009 and rolls over $200,000 from his 401(k) to a Roth IRA. He pays income tax on $200,000 of income. Matt dies in 2010 and leaves his Roth IRA to his wife Kim, who rolls that account to her own Roth IRA. In late 2010, Kim’s Roth IRA is worth $250,000.

If Kim withdraws all $250,000 right away, she will owe income tax on $50,000 worth of earnings because the Roth IRA will not have passed the five-year mark. Kim also will owe a 10% penalty on the full amount withdrawn ($25,000) because she is not yet 59½.

However, Kim can take a withdrawal of up to $200,000 from this Roth IRA at any time, free of income tax, as a return of the initial investment. She’ll owe income tax on withdrawals over $200,000 and the 10% penalty on all withdrawals until the Roth IRA meets the five-year and age 59½ requirements.

What if Kim keeps the inherited Roth IRA in Matt’s name? She can take income tax free withdrawals of up to $200,000 at any time and income tax free withdrawals of any amounts in 2014 and later years because the Roth IRA will have met the five-year requirement. In addition, Kim can withdraw any amount at any time without paying the 10% early withdrawal penalty because the tax code provides an exception for inherited IRAs. These withdrawals are, however, subject to the RMD rules.

Traditional IRA, from nonspouse
As a nonspouse IRA beneficiary, you can’t roll over the account to your own name. You can take all the money from the account and pay income tax on the pretax money you withdraw. Alternatively, you can transfer the account to an inherited IRA, as explained in the following example.

Example 3: Charles Baxter inherits an IRA from his mother, Alice. He transfers the account to an IRA in the name of “Alice Baxter (deceased) for the benefit of (f/b/o) Charles Baxter.”
Then Charles can take distributions as he wishes and pay the resulting income tax. Each year, no matter how old he is, Charles must take at least the RMD from this account, based on his official life expectancy. Life expectancy tables can be found in IRS Publication 590, Individual Retirement Arrangements (IRAs). If Charles withdraws less than the RMD amount, he’ll owe a 50% tax on the shortfall.

Roth IRA, from nonspouse
Again, you can either take the cash or transfer the account to an inherited Roth IRA in the name of the deceased IRA owner, for your benefit. You are subject to the RMD rules, determined by your life expectancy. All distributions will be tax free as long as the original Roth owner opened the account at least five years earlier. If you take out less than the RMD amount, you will owe a 50% penalty on the shortfall.

If you inherit any type of IRA from anyone, you probably will have the opportunity to stretch out distributions over many years, profiting from tax deferred or tax- free wealth accumulation inside the account. Missteps can deprive you of this chance to build wealth. Our office can guide you around the pitfalls of dealing with an inherited IRA.