How To Avoid Costly Missteps With An Inherited IRA


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Hundreds of thousands of people are expected to inherit an IRA this year. But a wrong step with an inherited IRA can be costly.

IRA heirs often lose valuable tax deferral due to an unintended distribution that triggers an unwanted tax bill, notes Ed Slott, editor of the IRA Advisor newsletter.

But age and marital status can give retirees special benefits with an inherited IRA.

A spouse often is the IRA beneficiary. A surviving spouse has a unique opportunity: She can roll it over to her own name.

Say a hypothetical Deb Lee is the beneficiary of her husband Al's IRA. When Al dies, she can roll the Al Lee IRA into a Deb Lee IRA.

Deb Lee can do this whether or not she already has her own IRA.

Once Lee has rolled over the IRA, she can name any beneficiaries she wants. And Lee can delay required minimum distributions until age 70-1/2, if she's younger.

At 70-1/2, if Lee does not need more money, she can take only RMDs, based on the IRS uniform lifetime table. That will allow her to stretch out withdrawals for many years, extending tax deferral.

Once the account is in her own name, Lee can convert all or part of her late husband's IRA money to a Roth IRA. No other IRA beneficiary can do that.

But Lee may need to tap the IRA right away. If so, rolling it to her own name can be costly.

If the IRA is in Deb Lee's name, she will owe a 10% penalty on withdrawals before age 59-1/2, unless she qualifies for an exception.

That penalty will be added to the ordinary income tax on IRA withdrawals.

Surviving Spouse Strategy

So a surviving spouse younger than 59-1/2 who needs payouts should not roll the account into her own IRA. Instead, depending on the custodian, it should be renamed something like "IRA of Deb Lee, spousal beneficiary of Al Lee."

In most cases it can be retitled in the name of the deceased spouse, for the benefit of the surviving spouse.

Then Deb can take withdrawals. She'll owe income tax but no penalty, because of the exception for inherited IRAs. She can do the rollover to her own IRA at 59-1/2.

The rollover permits her to name her own beneficiaries. She might have her own children from a prior marriage, for instance. It also lets her do a Roth conversion. And, if she no longer needs to tap the IRA, she can skip or reduce withdrawals until age 70-1/2.

For nonspouse beneficiaries, distributions are taxable. They can't take money from the IRA and put it back or re-deposit it elsewhere.

Nonspouse beneficiaries are not subject to the early withdrawal penalty. But they must take RMDs, no matter how old they are.

They can take more than RMDs, if they wish. But the less they withdraw, the more tax-deferred growth they get.

Say Jim Able inherits an IRA from his father Ed. The inherited account must be retitled, using both names. It could be "Ed Able IRA, deceased, fbo (for the benefit of) Jim Able, beneficiary."

As a nonspouse, you can't combine an inherited IRA with your own IRA. For maximum tax deferral, it's usually best to use the IRS single life expectancy table. Only an original owner can use the uniform lifetime table.

The single life table applies to inherited Roth IRAs and inherited traditional IRAs.

If an IRA has more than one beneficiary, have the custodian split it into an IRA for each heir by Dec. 31 of the year after death. That provides separate investment tactics and RMD schedules.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Mutual Funds

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