Options for Paying Taxes on Inherited Retirement Plans
You’ve inherited $50,000 in an IRA from your late father. “Wow, what an unexpected bonanza!” you say to yourself. “I’ll pay off my mortgage!”
Not so fast.
Unless you follow a maze of rules to the letter, you could end up signing over a chunk of that bonanza over to the IRS. The good news is that by better understanding the challenges you face and taking several well-planned steps, the money -- or most of it anyway -- will stay with you, just as your father wanted.
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The IRA Inheritance Problem
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Individual Retirement Arrangements, or IRAs, are not like regular savings accounts that you fund with your spare change and holiday bonuses. In most cases, you can put money in them untaxed and it is left untaxed for decades until it is withdrawn in retirement or inherited. If you inherit an IRA from a spouse, you can roll those funds into your own IRA and treat the money as your own. But if you inherit an IRA from someone other than a spouse -- a parent, for instance -- then your options narrow dramatically. You can pay up to 35 percent of the IRA’s value in income taxes, and additional amounts in estate taxes if the account is large enough, and take what’s left. Or, you can take steps to set up a trustee-to-trustee transfer, which can reduce your immediate tax liability.
Rename Your IRA
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The Internal Revenue Service places strict limits on the ways non-spouse inheritors may regard IRAs. The bottom line: You cannot treat the inherited IRA as your own. This means that you cannot make additional contributions to the IRA; if you try to roll it over into your own IRA, it will be taxed as cash income and you will probably face a penalty for excess contributions. However, you can “rename” the trust. According to the IRS “you can make a trustee-to-trustee transfer as long as the IRA into which amounts are being moved is set up and maintained in the name of the deceased IRA owner for the benefit of you as beneficiary.” So, as trustee of the IRA, you rename it “The John Smith IRA, maintained for the benefit of his son and heir, Robert Smith.” Though you still may not roll this new IRA into your own or contribute to it, you may take annual distributions for the course of your lifetime, paying the normal taxes on these distributions but paying no penalties. The amounts you take each year are based on your expected lifetime, according to IRS tables, and an annual amount that is calculated to exhaust the account by the time the IRS tables say you will die.
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Seek Sound Counsel
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Making a trustee-to-trustee transfer sounds easy enough, but be careful: Several common mistakes can derail your efforts. First, many lawyers, accountants and other “experts” in the estate planning field have rather flimsy knowledge of the rules governing inherited IRAs. IRAs came into being in 1974, and only now are the first baby boomers passing them on to spouses and children when they die. In the context of inheritance, IRAs remain somewhat new and mysterious. When you seek expert counsel on estate matters, make sure your adviser is up on the latest IRA rules.
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The common second mistake involves the trusts, family corporations, and other legal entities families often set up to protect estates. IRAs should be held by designated individuals or trustees, not by a non-human legal entity. Why? Because if IRAs are transferred to a family trust, then by law, one of two things must happen: 1) The money within them must be distributed to the owners of the trust within five years of the date the trust takes control of the IRA; or 2) the inheritors can follow the distribution plan of the original owner, assuming the owner had begun making required annual withdrawals at age 70.5. Either way, the inheritors will be forced to take distributions from the inherited IRA (and pay taxes) earlier than they may wish to.
Dates, Amounts and Deadlines
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The IRS places a host of deadlines and very detailed requirements on the IRA transfer process. For example, annual minimum withdrawals must be made by Dec. 31, even if estate and inheritance issues surrounding its ownership have not been finalized. Those missing this deadline can face a 50 percent withdrawal penalty in addition to the normal taxes levied on the money. There are other IRA schedules, deadlines and minimums lurking in the tax code as well. If you inherit an IRA, be proactive. Educate yourself on your options, hire experienced advisers, and work, without delay, on preserving your inheritance.
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