Differences Between a Beneficiary & Inheritance IRA
Individual retirement accounts are among the assets included in many estates. If you have inherited an IRA or are the executor for an estate with an IRA, understanding the difference between an inherited IRA and a beneficiary IRA is imperative to making the right financial decision with the asset.
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Inherited or Beneficiary
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An IRA names one or more beneficiaries. When the IRA owner dies, the group of beneficiaries are said to have an inherited IRA. This inherited IRA provides several distribution options to each beneficiary depending on his relationship to the deceased. Just because the beneficiary has an inherited IRA does not mean that a beneficiary IRA exists. The beneficiary IRA is one distribution option available to any living person inheriting the asset. A beneficiary IRA is not permitted for estate, family trust or charity beneficiaries.
Inherited IRA Options
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The inherited IRA can not remain as it is; it must be distributed in some fashion except when a surviving spouse is the beneficiary. A spouse may elect continuing the IRA as if it were her own, taking distributions based on her age and even making contributions she is eligible for. Other beneficiaries are excluded from this option.
A lump-sum distribution, in which all the money is taken out at once, is the only option for an estate, trust or charity inheriting the IRA. Another option is to take the payments over the five years following the IRA owner's death or to roll the money into a beneficiary IRA. The latter two options stretch out the IRA tax-deferred benefits and reduce immediate tax implications for distributions.
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Beneficiary IRA
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Electing the beneficiary IRA means you want to continue the tax-deferral on the money, only being required to withdraw minimum amounts each year. While any living person can elect this option, it is advantageous to a younger beneficiary -- a grandchild, for instance. Assume Sarah, age 10, inherits an IRA from Grandpa Joe. Sarah is not old enough to make the election, but Sarah's mom chooses to roll Joe's IRA into a beneficiary IRA for Sarah. All assets remain in the IRA with required minimum distributions taken each year based on Sarah's age, not Grandpa Joe's age at death. Required minimum distribution values are calculated based on life expectancy factors; a 10-year-old has a long life expectancy, so Sarah isn't required to take out a large amount each year and can save the IRA for college, home or her own retirement. Since it is a beneficiary IRA, she will never be penalized for early distributions, even if she isn't yet 59 1/2 years old.
IRAs and Taxes
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The IRA is included in the entire estate for federal tax purposes. An estate worth more than $5 million in 2011 is taxed at 35 percent. Traditional IRAs tax distributions as income, even to beneficiaries. At the highest tax bracket, this means the distribution is taxed at 35 percent. The options to stretch the IRA distributions over five years or to distribute them through a beneficiary IRA are extremely valuable ways to preserve the size of the IRA funds for beneficiary use.
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