Congress and the IRS made inheriting an IRA a very complicated, confusing event.
Inherited IRAs are accompanied by a host of little-known rules that are traps for the unwary.
In this post, I discuss the classic misunderstandings and mistakes about inherited IRAs. I’m not going to discuss the more recent difficulties brought by the enactment of the Setting Every Community Up for Retirement Enhancement (SECURE) Act in 2019 and the issuance of regulations under that law.
Those rules are important but are discussed in detail elsewhere.
There’s a host of under-the-radar rules beneficiaries need to know to minimize taxes and penalties and maximize the benefits of inherited IRAs.
Don’t contribute to an inherited IRA. It seems easier to add money to an inherited IRA instead of dealing with a separate IRA.
But the tax code prohibits contributions to an inherited IRA. Contributing any amount to the inherited IRA results in termination of the entire IRA. The IRA balance would be treated as distributed to the beneficiary in the year of the contribution and taxed as ordinary income.
Don’t convert an inherited traditional IRA to a Roth IRA. It’s simply not allowed.
You can take a distribution from an inherited traditional IRA, pay taxes on it, and contribute money to a Roth IRA.
But the contribution is limited to the year’s IRA contribution limit, and you must have earned income for the year of at least the amount you contribute.
Remember the annual contribution limit is per taxpayer, not per IRA. All contributions made to your IRAs during the year are aggregated to determine if you exceeded the limit.
IRAs inherited by multiple beneficiaries can be split tax free. Many people name all their children as equal beneficiaries of their IRAs. But the children can have difficulty agreeing on management of the IRAs.
The tax code allows the beneficiaries to divide the inherited IRA tax free into separate IRAs for each of them. Some IRA custodians require this of inherited IRAs, so they don’t have to deal with conflicts among the beneficiaries.
The split can be done whether the beneficiaries are all non-spousal beneficiaries or a combination of a surviving spouse and non-spousal beneficiaries.
To make it easy and maximize benefits, beneficiaries should make the split by December 31 of the year following the year the original owner died.
Be sure the custodian retitles the inherited IRA correctly. To defer taxes on an inherited IRA, the account must be retitled, and the new title must meet several requirements.
The title must include the deceased owner’s name, that he or she is deceased, the date of death, that it is an inherited IRA for the benefit of (or FBO), and then name the beneficiary. Some custodians also include the beneficiary’s Social Security number and that he or she is a beneficiary.
Don’t make the mistake of not changing the account title or changing it to the beneficiary’s name. In the first case, the IRA will have to be distributed in no more than five years. In the second case, the IRS will treat it as being fully distributed when the name is changed.
Most inherited IRAs can be moved to a different custodian. The tax code allows an inherited IRA to be moved tax free from one custodian to another. Many beneficiaries do this so the inherited IRA will be at the same financial services firm as their other assets.
First, confirm that the original IRA is retitled correctly, as just discussed. Then, be sure it is transferred to an IRA at the new custodian with the same title.
Finally, have the custodians transfer the money between themselves, especially if you’re a non-spousal beneficiary. Don’t take personal possession of the account, or it will be treated as a distribution.
There are some exceptions. A custodian might prohibit an IRA from being moved to another custodian or charge a fee to move the account. Some IRAs hold proprietary investments that can’t be transferred to another custodian, though it might be possible to liquidate the investment and transfer cash.
The 10% early distribution tax doesn’t apply. The penalty applies to many distributions to IRA owners before age 59½. But distributions made after the death of the original owner aren’t subject to the 10% penalty, no matter how young the IRA beneficiary is. Distributions from a traditional IRA will be included in gross income and taxed as ordinary income.
The five-year rule for Roth IRAs doesn’t apply. Original owners of Roth IRAs might need to wait five years to ensure all distributions are tax free. But the five-year rule doesn’t apply to inherited Roth IRAs. Distributions to beneficiaries will be tax free regardless of how long the IRA was open, how long the beneficiaries had Roth IRAs, or when an IRA was converted to a Roth.
Investments in the IRA can be changed. This is another move that might be limited by the custodial agreement. But as far as the tax code is concerned, an inherited IRA may be invested in anything an original IRA can own. Investments can be changed as soon as the beneficiary takes title to the IRA.
Beneficiaries should name successor beneficiaries. Suppose you inherit an IRA but pass away before the IRA is fully distributed.
The custodian’s records and policies determine who inherits next. The beneficiary usually has the right to name a successor beneficiary, and the custodian will transfer the IRA to whomever is named.
If a successor beneficiary isn’t named, the custodian’s policies determine who inherits. Usually, the IRA will be inherited by the beneficiary’s estate. It could be caught in the probate process, and taxes on its distributions might be higher than if an individual inherited them.
Surviving spouses have special privileges. A surviving spouse who inherits an IRA should know the unique planning opportunities available, such as titling the IRA in his or her own name and being exempt from the 10-year rule.
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