Inheriting an individual retirement account can be a very fortunate thing, if done correctly. The majority of us are left to our own devices when preparing for retirement, so the additional income from an inherited IRA can provide some relief.
But be forewarned, inherited IRAs come with a lot of rules – more than your own IRA. It is important that you take the time to learn about your new inheritance before you make any costly mistakes.
While we advise doing nothing before meeting with your financial advisor, here are 5 things you should never do with your inherited IRA.
Non-spouse Beneficiaries Not Using the Stretch Out Option
If you inherit an IRA and were not the spouse of the deceased, you have two options for liquidating the account. One option is you can choose is to “stretch” your distributions, which allows you to take required minimum distributions over your life expectancy. This leaves the funds in the IRA as long as possible, and could allow them to grow tax-deferred for decades. But just like a traditional IRA, you will still have to pay taxes on distributions and earnings from an inherited IRA. If you inherit a Roth IRA, you must still take RMDs, but these withdrawals will be tax free.
The second option is choosing to liquidate the account within 5 years of the owner’s death. While it might seem appealing to have the money right away, if you’re dealing with a traditional IRA you’ll likely be stuck with a huge tax bill, not to mention a long-term loss of earnings potential. Distributions from an inherited Roth IRA on the other hand will be tax free, unless the account wasn’t established at least five years prior to the owner’s death – then the earnings could still be subject to tax.
Not Taking RMDs
If you are a non-spouse inheriting an IRA and wish to “stretch” the IRA over your own life expectancy, you must take yearly required minimum distributions. Your RMDs must start the calendar year following the year that the owner died. If you miss that date, you will either have to take the five year lump sum option, or you will have to pay a 50% penalty on the amount that you should have withdrawn for that year. As a non-spouse, these rules also apply to inherited Roth IRAs.
It is also important to note, that if the owner of the IRA died before taking their RMD for that year, the non-spouse beneficiary must take the RMD on their behalf.
No 60 Day Rollover
To avoid unwanted taxation, you’ll want to request a trustee-to-trustee transfer directly from one account to another or from one IRA custodian to another when receiving an inherited IRA. For non-spouse beneficiaries, there is no 60-day rollover option. This means if you receive a distribution to then transfer into a new IRA, it will be taxed as ordinary income, even if it is well within the 60 day time frame. You will also be unable to deposit the money back into the inherited IRA.
Inherited IRAs Cannot be Commingled
If you happen to inherit multiple IRA’s from one individual, you can combine them into one IRA. However, if they are different types of IRAs, such as a traditional IRA and a ROTH, these cannot be combined into one account. Beneficiaries must also note that assets in inherited IRAs from different individuals cannot be combined.
Forgetting about Charity Beneficiaries
If an IRA has multiple beneficiaries, it’s important not to forget any charity beneficiaries that may be named. If the non-person entity’s share is not paid out by September 30 of the year following the owner’s death, all beneficiaries will no longer be able to take out withdrawals over their life expectancies. Instead, they will have to default to the five year rule and empty the account in five years if the owner died before his/her withdrawal date. If the owner died after their withdrawal date, beneficiaries will have to take RMDs based on the deceased’s life expectancy.
While we have only named five things to never do with your inherited IRA in this article, there are still a host of other mistakes to watch out for. It is important to contact a qualified financial advisor to make sure all the information you’re getting from the IRA custodian is correct. At Walsh & Associates, our team is ready to help you avoid any pitfalls with your beneficiary IRA. We welcome you to contact either of our two offices, located in Sarasota, FL and DeKalb, IL.