Cutter Family Finances: Inheriting An IRA: What You Need To Know
By: Jeffrey Cutter, February 5, 2014
Do you have an individual retirement account (IRA)? If you do, at the end of the day, do you plan to leave it to your kids? Better yet, do you expect to inherit an IRA?
Beneficiary IRAs were a hot topic of discussion at a meeting I attended for “Elite” financial advisors in Florida last week. We discussed how common it is to make mistakes when IRAs are passed on to the next generation. In fact, most of us agreed that many financial “professionals” do not even understand the rules. What I want to share with you today are some common scenarios involving Beneficiary IRAs and strategies to help you avoid unexpected taxes and penalties should you be lucky enough to inherit one.
First, let me explain to you the two most common types of IRAs, Traditional and Roth. With a Traditional IRA, tax deferred or “before tax” funds are contributed to a long-term tax shelter in the form of an Individual Retirement Account. All the earnings grow tax deferred, so in essence, money that remains in this type of IRA has not been taxed at all. Therefore, when money is withdrawn, the distribution is subject to income tax. A Roth IRA is very different. With a Roth, after-tax money is contributed, but withdrawals are tax-free. In either case, the IRA account can be left to a person’s heirs, subject to certain rules. Those rules differ depending on the relationship between the IRA owner and the heir. Let me give you two examples.
Scenario one is when a non-spouse inherits an IRA. The biggest mistake that people make in this situation is rolling the inheritance into his or her own IRA in his or her own name. You cannot do this! Both IRAs must remain separate. An inherited IRA must be classified as such and be titled either an “Inherited” or “Beneficiary” IRA. (If the money in an IRA is to be divided among more than one non-spouse heir, each recipient must establish a separate IRA account.) If this process is not followed correctly, two terrible things will happen (in addition to possibly exceeding the contribution limits for IRAs if the funds are combined). First, the inheritance will be classified as an IRA distribution under the rules of the IRS. That means Uncle Sam could get up to half of the inheritance as a result of penalties and taxes. Secondly, you will lose the glorious, multiyear tax shelter that an inherited IRA can provide. Let me explain.
Scenario two, when a person inherits an IRA from his or her spouse, is easier to understand. A spouse who inherits an IRA can either keep the funds in the existing account and put it in his or her own name, or roll the money, without paying any penalties, taxes or interest, into a new or existing IRA that is already in his or her own name, provided that either way the account is retitled as an “Inherited” or “Beneficiary” IRA.
I reached out to Attorney Geoff Nickerson, a partner at Oppenheim & Nickerson in Falmouth for his comments. “Keeping IRA funds in an inherited IRA account is critical,” Mr. Nickerson noted. “If money is taken from a decedent’s IRA and distributed to beneficiaries who then try to re-invest the money in an IRA, the beneficiaries will be taxed on the distribution. Take the time to consult with your investment advisor to be sure that you’re not running afoul of the IRS rules. While you may have every intention of re-investing IRA funds into another IRA, for tax purposes, once an IRA is distributed, the bell cannot be un-rung.” Good advice, Geoff.
There are a couple of additional points I want to caution our Cutter Family Finance readers about. If you inherit a Roth or Traditional IRA, you must begin systematic withdrawals or face stiff penalties.
Also, a point of caution for younger spouses is the potential for a 10 percent penalty if money is withdrawn from an inherited traditional IRA before the age of 59 1/2 if the spouse rolls over or transfers the IRA into their own name without retitling the account as either an “Inherited” or “Beneficiary” IRA. However, by following the rules, and renaming the account as an “Inherited or Beneficiary” IRA, a spouse can avoid this penalty, even if he or she withdraws funds before the age of 59 1/2.
Bottom line: Correct titling is critical, if you get it wrong, you could face significant penalties and taxes. If you use a financial services firm, make sure to use one that employs IRA experts. If you are a “do it yourself” investor, I suggest that at the very least, you give your heirs explicit instructions explaining the importance of proper retitling. You want your heirs to get as much tax deferral as they can from the money you leave them.
Be vigilant and stay alert, because you deserve more.
Jeffrey Cutter, CPA, PFS, is the managing partner from Cutter Financial Group, LLC (www.cutterfinancialgroup.com), which provides private wealth and investment management through low risk, low volatility successful financial solutions. He can be reached at firstname.lastname@example.org.
Investment advice is offered by Horter Investment Management, LLC, a Registered Investment Adviser. Insurance and annuity products are sold separately through Cutter Financial Group, LLC. Securities transactions for Horter Investment Management clients are placed through Pershing Advisor Solutions, Trust Company of America, Jefferson National Monument Advisor, Fidelity, Security Benefit Life, and Wells Fargo Bank, N.A.