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An Inherited IRA is a retirement account that is left to a beneficiary after the owner’s death.  It is important to have a general knowledge of how Inherited IRA’s work because a minor error in how the account is set up could lead to major tax consequences.

Before going into the different kinds of Inherited IRA’s, if you are the sole beneficiary of your spouse’s IRA, you are able to transfer the assets to your own existing IRA or to a new IRA through what is called a “Spousal Transfer”.  This account is not treated as an Inherited IRA and therefore is subject to all the rules a Traditional IRA would be subject to as if it was always held in your name.  If the spouse needs to have access to the money before age 59 ½, it would probably make sense to set up an Inherited IRA because this would give the spouse options to access the money without incurring a 10% early withdrawal penalty.

Withdrawal Rules for Spouse & Non-Spouse Beneficiaries

 

Once an Inherited IRA account is opened, distributions are required from the account no matter your age.  If the Inherited IRA was originally from a pre-tax account (i.e. Traditional IRA, SEP, SIMPLE IRA) then each distribution will be subject to tax.  If it is an Inherited Roth IRA, there will be no tax consequence on these distributions.  Also, since it is an Inherited IRA and you are required to take distributions, you will not have to pay the 10% early withdrawal penalty if you are under the age of 59 ½.

Different Ways to Set Up an Inherited IRA

 

The two most common ways to set up an Inherited IRA are mentioned below.  The way the funds are distributed is dependent on how the Inherited IRA is set up and it is important to speak with your financial advisor and tax preparer to determine which method is best for you.

Life Expectancy Method

 

A calculation is used to determine the distribution amount needed annually spread over your single life expectancy.  It is important to know that a distribution must be taken by 12/31 of the year following death or this method is no longer an option because there must be an annual distribution.  In this case, the funds will be subject to the 5 year method explained next.

5 Year Method

 

All the assets must be distributed by the 5th year after the year in which the account holder died.  This method is no available if the account holder was older than 70 ½ at the time of death.  This option may make sense compared to the Lump Sum option explained next to spread out the tax liability over a longer period.

Lump Sum Distribution

 

You may take a lump sum distribution when the account is inherited.  It is recommended that you consult your tax preparer to discuss the tax consequences of this method since you may move up into a different tax bracket.

Additional Takeaways

 

If the decedent was required to take a distribution in the year of death, it is important to determine whether or not the decedent took the distribution.  If the decedent was required to take a RMD but did not do so in the year they passed, the inheritor must take the distribution based on the life expectancy of the decedent or the distribution will be subject to a 50% penalty.  Distributions going forward will be based on the life expectancy of the inheritor.

It is important to be sure a beneficiary form is completed for the Inherited IRA.  If there is no beneficiary and the account goes to an estate then the inheritor will have limited choices on which distribution method to choose among other tax consequences.

You are only able to combine Inherited IRA’s if they were inherited from the same individual.  If you have multiple Inherited IRA’s from different individuals, you cannot commingle the assets because of the distributions that must be taken.

There is no 60 day rule with Inherited IRA’s like there is with other Traditional IRA’s.  The 60 day rule allows someone to withdraw money from an IRA and as long as it’s replenished within 60 days there is no tax consequence.  This is not available with Inherited IRA’s, all non-Roth distributions are taxable.

The charts below are from insurancenewsnet.com publication titled “Extended IRA Quick Reference Guide” give another look at the details of Inherited IRA’s.

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Rob Mangold

About Rob………

Hi, I’m Rob Mangold. I’m the Chief Operating Officer at Greenbush Financial Group and a contributor to the Money Smart Board blog. We created the blog to provide strategies that will help our readers personally , professionally, and financially. Our blog is meant to be a resource. If there are questions that you need answered, pleas feel free to join in on the discussion or contact me directly.

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Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.