A Little Bit of Planning Can Go a Long Way When It Come to Inherited IRAs

Published on April 4, 2013

When inheriting an IRA from a deceased spouse or parent, a lot more is involved than just transferring the assets or funds to a new bank account. The IRS has established certain rules that must be followed to avoid having the entire amount of the inheritance taxed immediately.

Although there are several perks to owning an individual IRA account, like having the interest, dividends, and capital gains grow tax-deferred, an inherited IRA must go through the process of being renamed or retitled to reflect the status change. Again, if this name change doesn’t take place, the beneficiary may face tax penalties.

However, these requirements do not just apply to IRAs, previous employer 401(k) plans are subject to the same rules as IRAs when it comes to retitling. Although most individuals rollover funds from their 401(k) to an IRA upon retirement, it is important to know what types of retirement plans the deceased held.

This knowledge is particularly important since the baby boomer generation is growing old. They are inheriting IRAs from deceased spouses and parents, and the number of tax issues related to inherited IRAs is steadily increasing. It seems that many people, including some financial planners, are unaware of the requirements the IRS has put on inherited retirement plans. For example, a surviving spouse does not need to retitle the deceased spouse’s retirement plan if they held a traditional IRA. Additionally, this will allow the surviving spouse to defer taking distributions until age 70 ½. Younger spouses who may need the money before age 59 ½ will face a 10% tax penalty for taking an early distribution. However, younger spouses can avoid the 10% penalty if they retitle the IRA to an inherited IRA. If younger spouses who retitle the account to an inherited IRA are smart, they can retitle the IRA again at age 59 ½ in order to defer any further withdrawals until age 70 ½.

Children and/or non-spouse inheriting the IRA are required to immediately retitle the IRA to avoid penalties are mandated to take a yearly distribution (known as a death distribution) based on the account’s value. If the beneficiary of the inherited IRA dies before depleting the account, their beneficiary must again retitle the IRA to avoid penalties, and so on.

Should you find yourself the recipient of an inherited IRA, your best choice is to immediately consult your financial planner or tax advisor to ensure that you follow IRS guidelines. Once an inherited IRA is distributed for neglecting to retitle, the process cannot be undone and the entire account balance will be distributed. For more information on inherited IRAs, check out the article by Post-Gazette.com, “Planning can help avoid tax penalties and ensure growth for inherited IRAs.”