If you don’t want the money, you can always disclaim (refuse to accept) the inherited IRA or plan funds. But if you’re like most people, you will want the money. Your first thought may be to take a lump-sum distribution, but that’s usually not the best idea. Although a lump sum provides you with cash to meet expenses or invest elsewhere, it can also result in a huge income tax bill (in most cases, due all in one year). A lump-sum distribution also removes the funds from a tax-deferred environment. Fortunately, you probably have other alternatives.
If you are the designated beneficiary (i.e., you are named as beneficiary in the IRA or plan documents), you can take distributions over your remaining life expectancy, which spreads the income and tax liability over a number of years. You must calculate the annual required minimum distribution (RMD) amount that must be withdrawn each year using IRS life expectancy tables. (You can always withdraw more than the minimum amount in any year, but you will generally be subject to a 50% tax penalty on any required amount that is not withdrawn.) Yearly distributions from the IRA or plan must begin by December 31 of the year following the year of the original account owner’s death. If there are other designated beneficiaries and separate accounts have not been set up, the oldest beneficiary must be used for the life expectancy calculation. (Note: An employer-sponsored retirement plan can specify the distribution method that beneficiaries must use.)
You may have other options as well. If the IRA owner or plan participant died before he or she began taking RMDs, you can generally elect to distribute the entire interest in the IRA or plan within five years of the owner’s or participant’s death. (In this case, you don’t have to begin taking distributions the year after death.) If the IRA owner or plan participant died after beginning to take RMDs, you may be able to spread distributions over the owner’s remaining life expectancy (calculated in the year of death) if that period is longer than your own life expectancy. (Be sure to first withdraw the RMD for the year of death, if not yet taken by the IRA owner/plan participant.) Again, keep in mind that an employer-sponsored retirement plan can specify the distribution method that beneficiaries must use. If your choices are limited by a plan, you may have the ability to transfer the plan funds to an IRA established in the deceased IRA owner’s or plan participant’s name — the rules that apply to inherited IRAs would apply to the transferred funds.
If you are a surviving spouse and a designated beneficiary of the IRA or plan you may also have additional options. You can roll over inherited traditional IRA or plan funds into your own traditional IRA or retirement plan. If you’re the sole beneficiary, you can also leave the funds in an inherited IRA and treat it as your own IRA. In either case, you can then name beneficiaries of your choice and defer taking distributions until the required age (usually 70½). You can generally also roll over (“convert”) non-Roth distributions from an employer plan into a Roth IRA (you’ll generally pay tax on the converted funds in the year of the conversion, but qualified distributions from the Roth IRA will be tax free).
If you’re a nonspouse beneficiary, you generally have far fewer options. For example, you can’t roll the funds in an employer retirement plan into your own IRA or plan account, but you can generally have the funds transferred directly to a properly titled inherited IRA (for example, Joy Smith, deceased, for the benefit of Mary Smith, beneficiary). You can also roll over (“convert”) non-Roth distributions from an employer plan into an inherited Roth IRA (however, you must do so in a direct rollover, and pay tax on the converted funds).
Finally, Roth IRAs are subject to similar rules. If you inherit a Roth IRA, you can take distributions over a five-year period (following the Roth IRA owner’s death) or over your remaining life expectancy. Although original Roth IRA owners are not subject to RMDs, Roth IRA beneficiaries must take them. However, if you are a surviving spouse beneficiary, you may be able roll the assets over to your own Roth IRA or, if you’re the sole beneficiary, treat the Roth IRA as your own. This is significant because, as a Roth IRA owner (rather than beneficiary) you do not have to take any distributions from the Roth IRA during your lifetime. Distributions from an inherited Roth IRA are usually free from income tax if made at least five years after the deceased IRA owner first contributed to any Roth IRA.
*You cannot roll over RMDs. When evaluating whether to initiate a rollover always be sure to (1) ask about possible surrender charges that may be imposed by both the distributing plan and the receiving plan, (2) compare investment fees and expenses charged by your IRA (and investment funds) with those charged by your employer plan (if any), and (3) understand any accumulated rights or guarantees that you may be giving up by transferring funds out of an employer plan. The rules governing inherited IRAs and employer-sponsored plan accounts are complex. Consult a tax advisor for more information.
The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from a professional tax, legal and/or investment advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security.