Inherited IRAs—What You Need to Know
Since first developed more than 40 years ago, Individual Retirement Accounts (IRAs) have become a popular retirement savings vehicle for generations of investors. As time marches on, a new generation of IRA investors is emerging-one that has inherited, or will inherit an IRA from a parent, spouse or other person.
FINRA is issuing this alert to inform brokerage account holders, family members and other beneficiaries about inherited IRAs. We also provide tips for making the IRA inheritance process as efficient and trouble-free as possible.
Where to Begin
When you open an IRA you generally name a beneficiary. This could be a spouse, children or other individuals, a trust or charity, or some combination. For inheritance purposes, the named IRA beneficiary takes precedent over a will or trust.
No Beneficiary? If an IRA has no named beneficiary, check the IRA agreement to see how the IRA custodian handles the situation. The agreement will either default to a "designated" beneficiary or an estate, and be subject to the appropriate distribution rules.
When the owner of an IRA dies, brokerage firms generally have systems in place for beneficiaries to follow-a process that usually starts by filling out a beneficiary claim form. If the beneficiary is an estate, and you are the executor, you will likely start with the department of a brokerage firm that handles estate matters. Many firms also provide information about inherited IRAs, such as distribution rules, including information about Required Minimum Distributions (RMDs) , and the consequences of withdrawing funds from an IRA.
The IRS also provides important taxpayer information for beneficiaries of inherited IRAs and other retirement vehicles. Due to the complexity of the income tax and estate planning implications of inheriting an IRA, you may want to consider consulting with a tax specialist if you inherit an IRA.
Key Factors on Distributions
People who inherit IRAs often have questions about when and how they can withdraw money from the account-and when they must take a distribution. IRS rules regarding distributions are influenced by a number of factors, including the following:
• Age. As with IRAs in general, age can be a factor that influences RMD payments, potential penalties and other aspects of inherited IRAs. For example, whether the account holder dies before or after 70½ (the age the IRS requires you to take minimum withdrawals from a traditional IRA) has implications for beneficiaries of inherited IRAs. Age 59½ is also an important age, especially for surviving spouses who decide to roll the account balance into their own IRA accounts (traditional or Roth) and subsequently withdraw the funds. If the spouse seeks to withdraw any of the funds before reaching age 59½, a 10 percent early withdrawal penalty likely will apply.
• Account type. The type of IRA (traditional or Roth) that is inherited is another key factor influencing distributions. In general with any inherited IRA, you must take distributions during your lifetime or within five years after the death of the original account holder. If you inherit a Roth IRA, you don't pay taxes on distributions (although earnings generally will be taxable if withdrawn before you are age 59½ and until a five-year holding period has been met). If you inherit a traditional IRA, you'll generally pay taxes on the distributions you take in excess of the deceased account holder's basis, which will depend on whether the decedent's contributions were deductible or nondeductible. (See IRA with basis in IRS Publication 590-B ).
• Relationship. Perhaps the most important factor influencing the distributions of an inherited IRA is the relationship of the account holder to the beneficiary. Different rules and options for handling the inherited IRA apply to spouses and non-spouses, which are discussed in more detail below.
RMDs Are Important Required minimum distribution rules depend on a number of factors. Most important is whether the beneficiary is a spouse who treats the IRA as his or her own, or whether the IRA is inherited by a non-spouse or "stretched." For more information, see RMD Basics for Inherited and Stretch IRAs .
When a Spouse Inherits
In many cases, it is the surviving spouse who is the named beneficiary and inherits an IRA. If that is your situation, you have a number of options:
• Treat the inherited IRA as yours by designating yourself as the account holder. In short, you create a new IRA in your name. The IRA (traditional or Roth) becomes yours, and RMDs are determined as if you were the owner beginning with the year you elect or are deemed to be the owner.
• Treat the inherited IRA as yours by rolling it into a traditional IRA you already hold or into a qualified employer plan such as a 401(k) or 403(b) set up in your name . The assets are then treated as your own.
• Treat yourself as the beneficiary (as opposed to becoming the account holder). In essence, you create an "inherited IRA," into which the assets of the original IRA are transferred. Depending on the age of the original account owner upon death, you can elect to take distributions over your own or the original account owner's life expectancy, sometimes referred to as the "life expectancy method," or over a five year period.
• Take a lump-sum distribution.
• You may incur taxes on the distribution for a traditional IRA.
• For a Roth, only earnings are taxable if the account is less than five years old at the time of the account-holder's death.
• You will not incur a 10 percent early withdrawal penalty even if you are under age 59½.
• Decide not to take ownership of all or part of the IRA. This is referred to as "disclaiming" or "renouncing" the inheritance. There may be estate or tax reasons for doing so, and it's important to consult with an attorney to ensure legal requirements are met.
When a Non-Spouse Inherits
If the inherited IRA is from anyone other than a deceased spouse, you have fewer options.
• Transfer the assets into an inherited IRA in your name. Non-spouse beneficiaries cannot treat an inherited IRA as his or her own (as spouses can). As such, they can't make any new contributions to the IRA or roll over any amounts into or out of the inherited IRA. The IRS does, however, allow for moving the IRA to another firm via a trustee-to-trustee transfer that meet certain conditions.
• If you inherit a traditional or a Roth IRA , required minimum distributions are mandatory . Distributions must begin no later than December 31 of the year following the death of the original owner of the IRA. These distributions may have tax implications, such as landing you in a higher income tax bracket.
• Take a lump-sum distribution (same as spouse option).
• You may incur taxes on the distribution for a traditional IRA.
• For a Roth, only earnings are taxable if the account is less than five years old at the time of the account -holder's death.
• You will not incur a 10 percent early withdrawal penalty even if you are under age 59 ½.
• Decide not to take ownership of all or part of the IRA (same as spouse option) by "disclaiming" or "renouncing" the inheritance. As for spouses, there may be estate or tax reasons for doing so, and it's important to consult with an attorney to ensure legal requirements are met.
If an IRA has multiple beneficiaries, it's generally suggested that beneficiaries set up separate accounts. If separate accounts are not established, the amount of the required distributions for all beneficiaries are determined based on the age of the oldest beneficiary. Since required distributions are based on life expectancy, the younger you are, the less you are required to take annually. This is a key reason tax and financial professionals tend to counsel the establishment of separate accounts for each beneficiary.
The IRS notes that the designated beneficiary (or beneficiaries) is generally determined on September 30 of the calendar year following the calendar year of the IRA owner's death, referred to as the "distribution date." For instance, assuming the owner passes away in 2016, determination of the account beneficiaries is made on September 30, 2017.
Properly Title the IRA Account
To keep the tax-advantages of an IRA, it must be titled in such a way to make clear that the IRA has been passed on to a beneficiary. IRA experts tend to recommend a format such as "Jane Doe, deceased (insert the date of death), F/B/O (for benefit of) Jimmy Doe, Beneficiary."
It's also a good idea to make sure the appropriate Social Security Number relates to the applicable beneficiary. Beneficiaries should keep a copy of the beneficiary designation for their records-and check that the statements received show the proper titling.
Also, all of the money in the traditional IRA is treated as income in the year that the retitling occurred, which can have significant tax consequences.
Working with a Brokerage Firm
Although the choices you have and the tax implications of each can be complicated, the actual transition of IRA assets from a decedent's account to a beneficiary is often a fairly smooth process. This is because beneficiary designations are frequently used in retirement plans, including IRAs, to determine who is entitled to account assets. When you designate an IRA beneficiary, that person inherits your assets when you die, regardless of your will or trust.
When a brokerage firm is notified of the death of an IRA account holder, it generally sets in motion a fairly straightforward process that starts with each beneficiary completing a beneficiary claim form. In many cases, the form requires that your signature be Medallion Guaranteed .
Usually firms will speak only with designated beneficiaries. Be prepared to provide a copy of the death certificate, as well as personal information verifying your own identity, such as your Social Security Number or other information that the firm may require. Specific requirements to complete the transfer process may vary by firm.
Tips for Heirs and Beneficiaries
If you are a beneficiary of an IRA, these tips can help the ownership transition process go smoothly:
• Notify the brokerage firm in a timely manner of an account holder's death. If you aren't sure whether the IRA is held in a brokerage account, keep an eye out for account statements or other indications that an account exists.
• Provide all required documents, in the format and manner stated by the brokerage firm . Notify the brokerage firm if you have questions about the documents they are requesting, or if you aren't sure how to obtain them.
If you are a spouse who elects to treat an IRA as your own, here are two additional tips (these don't apply to beneficiaries of an inherited IRA, who may take distributions only):
• Know what you own. Upon taking ownership of the assets, take time to understand your investment holdings and determine whether they are right for you. In particular, learn about the risks of each investment, if there are any restrictions on when you can sell the investment (liquidity risk) and any fees associated with the investment. FINRA offers information about investment products and key investment concepts .
• Investigate the pros and cons of selling investments. If you plan to sell assets within the IRA, there likely will be costs from the sale. Selling decisions should be in keeping with your overall investment objectives. Consider consulting an investment professional for guidance.
• Assess whether the current brokerage firm and broker are right for you . You are not required to stay with the deceased's brokerage firm, or the broker who handled the account-and you should not be pressured to do so. That said, you should not feel compelled to transfer your account to another brokerage firm. Before you consider a transferring the assets you inherit or buying new ones, be sure to check the background of the investment professional using FINRA BrokerCheck .
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