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If you inherited a retirement account or IRA from someone other than your spouse, you have to take action before December 31st of the year following the person’s death, otherwise your options will be limited and you could be facing a huge tax liability.

Deadline To Set Up An Inherited IRA

 

December 31st of the year following the decedent’s date of death is important because that is your deadline to set up and fund an inherited IRA.  If you miss that deadline, you will be forced to withdraw all of the assets from the IRA within a 5 year period.

Taxation

 

When distributions are made from a decedent’s IRA to a beneficiary, the amount is taxed as ordinary income to the beneficiary.  Since they are considered “death distributions” by the IRS, regardless of the age of the beneficiary, they do not incur the 10% early withdrawal penalty for being under the age of 59½.  However, if there is $200,000 in the IRA account and you miss the December 31st deadline to set up your inherited IRA, you will now be forced to take out the full $200,000 within a 5 year period which usually means that you will have to give more to government in the form of higher tax rates.

How An Inherited IRA Works

 

Instead, most beneficiaries of an IRA or retirement account will choose to set up an inherited IRA.  By setting up an inherited IRA, it allows you to rollover the balance from the decedents IRA into your own inherited IRA tax and penalty free.  As a non-spouse beneficiary, you are allowed to stretch out the distributions from the IRA account over your life expectancy as opposed to just 5 years.

The IRS does require you to take a distribution from the account each year. These are called “required minimum distributions” (RMD).   However, you can always take more than the RMD amount.  Regardless of the amount withdrawal, the distributions are not subject to the 10% early withdrawal penalty even though the owner of the inherited IRA is under the age of 59½.

At the end of the year you will receive a 1099R tax form from the investment provider of your inherited IRA which details:

  • Total amount withdrawn from your inherited IRA
  • Total fed tax withholdings
  • Total state tax withholdings

You will include those amounts in your tax return.

Required Minimum Distributions

 

You are required to take your first RMD by December 31st of the year following the decedent’s date of death.  If you miss that deadline, the IRS hits you with a 50% penalty based on the amount that should have been taken for the RMD.   After the first distribution, you are required to take your RMD each year by December 31st.

As a non-spouse beneficiary you have to make sure you are using the correct table when calculating your RMD.  Non-spouse beneficiaries use the Single Life Expectancy Table provide by the IRS.  Find your age in the table and it will provide you with a number for your life expectancy.  You take your 12/31 balance from the previous year and divide it by your life expectancy to determine your RMD amount.   Once you have completed this exercise for the first year, you will simply subtract 1 from that life expectancy number each year. You do not need to return to that IRS table each year to calculate your RMD amount.

Tax Offset Strategy

 

If you do no need the additional income from your RMD, there is a strategy that will help reduce the tax hit caused by the requirement minimum distribution for your inherited IRA.  If you are covered by an employer sponsored retirement plan, you can request your RMD from your IRA at the beginning of the year.  Once the RMD is in your checking account, you can contact your employer and instruct them to increase your pre-tax contributions to your employer sponsored retirement plan.  You will use the cash sitting in your checking account from the IRA distribution to supplement the income that you are losing from the increased contributions to your employer sponsored plans.

Using this strategy,  you receive additional taxable income from the inherited IRA but then you wipe out the tax liability by contributing that same amount to your employer sponsored retirement plan pre-tax.  Thus, lowering your taxable wages by the amount of the IRA distribution.  Bingo!!

 

Michael Ruger

About Michael………

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

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