Pass It On: Inheriting an Individual Retirement Arrangement
The first Individual Retirement Accounts (IRAs) were created by the Employee Retirement Income Security Act (ERISA) in 1974. Since then, the spotlight has been on promoting the creation, funding and use of IRAs. Recently, however, another side of IRAs has begun coming into the light: inheriting IRAs.
In general, only surviving spouses can treat inherited IRAs as their own. Everyone else should rename the inherited IRA to be “for the benefit of (the beneficiary)” to reduce the income tax owed on the amount inherited. Also the beneficiary must take their first distribution before December 31 of the year after the owner died. A 50 percent penalty will be assessed if it isn't. If the deceased was taking required minimum distributions, which begin at age 70½, and distributions taken by the account owner prior to death become the property of the estate. Distributions that have not been made prior to death become the property of the designated beneficiary but must be taken before December 31 the year the owner of the IRA dies or a penalty is incurred.
Inheriting Traditional IRAs
Any person or entity chosen by the account owner can inherit, or be the beneficiary of, a traditional IRA. For tax purposes, beneficiaries of traditional IRAs must include their gross income in any taxable distributions received.
If a traditional IRA is inherited by a spouse, the surviving spouse can treat the IRA as their own either by designating themselves as the account owner, rolling it into their own traditional IRA, or, to the extent it is taxable rolling it into another retirement plan. A distribution from a deceased spouse's IRA can be rolled into the surviving spouse's IRA, even if the surviving spouse is not the sole beneficiary, within a 60-day period as long as the distribution is not a required distribution. A distribution received by a surviving spouse can be rolled into another traditional IRA and not be included in income for the year it is received.
If the beneficiary of a traditional IRA is someone other than the surviving spouse, they cannot treat the IRA as their own. If the total amount of an inherited IRA is rolled into the beneficiary's IRA, the beneficiary must pay income tax on the entire amount although the funds would remain in a tax-deferred account. To limit the tax burden, the beneficiary can make a trustee-to-trustee transfer as long as the destination IRA is set up and maintained in the name of the deceased IRA owner for the benefit of the beneficiary. Changing the name of the IRA to “John Doe IRA F/B/O (for the benefit of) Johnny and Janie Doe” allows the beneficiary to make annual withdrawals over the course of their lifetime, paying smaller amounts of tax on the withdrawals and allowing the bulk of the amount to continue growing tax-deferred.
If the IRA is inherited from a person who had a basis in the IRA because of nondeductible contributions, that basis remains with the IRA. The basis cannot be combine with the beneficiary's basis unless the IRA is inherited by a surviving spouse who treats it as their own. In all other cases, individuals taking distributions from both an inherited and personal IRA, where each has basis, the taxable and nontaxable portions of the distributions must be determined separately.
The beneficiary of a traditional IRA can deduct the estate tax paid on any part of a distribution that is income in respect of a decedent in the year the income is reported.
Inheriting Roth IRAs
When the owner of a Roth IRA dies, the minimum distribution rules applicable to traditional IRAs apply to Roth IRAs as if the owner of the Roth IRA died before their required beginning date. The entire interest in the Roth IRA must be distributed by the end of the fifth calendar year after the death of the owner unless the interest is payable to the beneficiary over their life expectancy. If the sole beneficiary is a surviving spouse they may treat the Roth IRA as their own or delay distributions until the decedent would have reached age 70½.
An inherited Roth IRA can be combined with another Roth IRA if the beneficiary
- Inherited both Roth IRAs from the same individual
- Is the surviving spouse and sole beneficiary of the Roth IRA and treats it as their own.
Distributions to a beneficiary that are not qualified distributions are generally included in the beneficiary's gross income in the same way it would have been included in the decedent's income had they received it.
If the owner of a Roth IRA dies before the end of:
- The 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for the owner's benefit.
- The 5-year period starting with the year of a conversion contribution from a traditional IRA to a Roth IRA.
each type of contribution is divided among all designated beneficiaries according to a pro-rata share of each.
Sometimes, unfortunately, no beneficiary is designated or there is no living beneficiary of an IRA. When this happens the account goes to probate with the rest of the estate. If the owner of the IRA died before any distributions are taken, all the funds must be withdrawn from the account by the heirs within five years of the owner's death. These withdrawals are taxed like regular income.
As more IRAs are inherited, it is likely these rules will also change. In the meantime, more information on inheriting IRAs is available from IRS Publication 590. Other helpful information can be found in Individual Retirement Account Answer Book and Quick Reference to IRAs, 2004/2005 from Aspen Publishers.