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November, 2004 To Your Wealth/Michael P. Haubrich,
CFP IRA
Inheritance Options |
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An increasing number of
beneficiaries are inheriting individual retirement accounts as
first-generation investors begin dying and leaving their IRAs to their
survivors. Understanding what to do upon inheriting an IRA is an important
investment strategy that requires careful consideration to avoid losing
potential earnings or paying extra taxes. The beauty of an inherited IRA is
that the money can keep growing for decades after the death of the original
owner. The IRS does require that a minimum withdrawal be made each year and
the penalties for failing to do so are some of the most severe in our
existing tax code. Traditional IRA inheritance rules vary and it is
recommended to work with your financial advisor to ensure that that you are
aware of your options and that your decisions are consistent with your
financial life planning objectives.
An inherited IRA can represent a
tremendous financial windfall if handled appropriately. Often time, in the heat of the emotional
tumult that comes with the death of a parent or spouse,
inheritors of the IRA don’t recognize the long-term earning potential and tax
advantages associated with the IRA.
A surviving spouse has three
options upon inheriting an IRA. The
final decision of what to do will be driven by factors such as the survivor’s
age at the time of inheritance, the age of the IRA owner at the time of
death, whether required withdrawals had already begun, and other financial
life planning considerations. Options
for non-spouses are different than those for spouses. One option for the inheriting
spouse is to cash in some or all of the IRA and pay the income tax on the
withdrawal. Another option is to leave the IRA in the deceased’s name. And finally, a spouse can roll it over into
a new account in the survivor’s name. If the spouse is younger than age
59 ½ and needs money from the IRA to cover living expenses, he or she can
make withdrawals before age 59 ½ without paying the 10 percent early
withdrawal penalty, however, ordinary income taxes will still be due. It’s important to note that if the spouse
in this case opts to the roll the inherited IRA into his or her own IRA, then
early withdrawals would be subject to the 10 percent penalty. It may make more sense for a
surviving spouse over the age of 59 ½ to roll the inherited IRA over into an
IRA in their own name, which allows them to name their own beneficiaries and
delays the minimum distribution until the surviving spouse turns 70 ½ . Minimum distributions would then be based
on the heir’s life expectancy. IRA inheritance rules for
non-spouses are different than in the case of a spouse. If the IRA did not
designate a beneficiary and the owner already started required distributions
after the age of 70 ½, the heir must continue taking out distributions based
on the owner’s life expectancy at death.
If distributions had not started, their heir must take all the money
out within five years and pay ordinary income taxes but not the early
withdrawal penalty. If the IRA designated a non-spouse
beneficiary, they can not roll an inherited IRA into their own IRA. Rather, they can establish a “beneficiary
IRA,” which remains in the name of the deceased original owner but for the
benefit of the heir. That beneficiary
also takes minimum withdrawals based on his or her own
life expectancy rather than the life expectancy of the original owner
regardless of when or if required distributions had begun. Dealing with the implications of
inheriting an IRA can be very complicated and there is much more to this strategy
than has been highlighted in this article.
If you find yourself as a beneficiary to an IRA, be sure to work with
a financial advisor
who is familiar with IRA inheritance rules so you can explore
the best option for your individual situation.
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