Inheriting an IRA can provide a person with much needed additional income. However, receiving distributions from these accounts can be quite costly to the recipient if the rules are not understood. When and how you take distributions from an inherited IRA is affected by who and how old the person you inherited the account from was. In general, inherited IRAs are split into two groups – IRAs inherited from a spouse and IRAs inherited from a non-spouse. The category you fall into will affect the timing of distributions and can dramatically increase taxable income. However, careful planning can mitigate tax penalties while providing a new stream of income.
IRAs Inherited from Spouses
When you inherit your spouse’s IRA, you can choose from several courses of action:
1. Transfer the assets into your own IRA account. This choice allows you to keep the assets in the IRA account where the assets can grow tax free. The account is also protected from creditors. Access to the assets is subject to traditional IRA rules. For all intents and purposes, this path treats the inherited IRA as if you were the original owner of the account.
2. Take a lump-sum distribution. This choice will not subject you to the 10% early withdrawal, but it may bump you into a higher tax bracket. While this will give you immediate access to the entirety of the account, it may be punitive tax-wise if you have been in a lower tax bracket before you received the distributions.
3. Transfer assets into an Inherited IRA (beneficiary approach). This approach allows you to avoid the 10% early withdrawal penalty and can allow you to keep the assets growing tax-deferred. Distribution rules, however, are dependent on the date of death of the original owner. These rules are complex and we recommend you discuss the potential tax impacts with your tax professional. In general, however, if the owner died before reaching the age of 70.5, distributions do not need to begin until the year in which the owner would have reached 70.5.
IRAs Inherited from Non-Spouses and the Five-Year Rule
IRAs inherited from non-spouses are subject to different distribution rules because you cannot roll non-spousal inherited IRAs into your own IRA. An additional element is also introduced into the equation – the designated beneficiary. A designated beneficiary is an individual who is named by the IRA owner to be entitled to some portion of the IRA upon the original owner’s death. A designated beneficiary must have a quantifiable life span because that life span is used to calculate required minimum distributions. These distributions must begin no later than December 31st of the year after the original owner’s death. A designated beneficiary cannot be an entity.
Non-designated beneficiaries can receive proceeds from an inherited IRA but, they are subject to the 5-Year Rule. The 5-Year Rule requires that the entire balance of the inherited IRA be distributed by the end of the fifth year following the original owner’s death. Spreading distributions received over five years can help smooth income tax effects but very large IRAs can still push incomes into higher than expected tax brackets. It is important to note that if the original owner dies after reaching minimum distribution age, the 5-Year Rule cannot be applied.
If you have any questions regarding inherited IRAs, please contact your L&B professional at (858) 558-9200. Properly planning and timing income from these accounts can be complicated but financially rewarding if done properly.