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4 Steps to Take When You Inherit an IRA

Retirement Planning Financial Planning Tax Planning Wealth Transfer IRA Strategies Roth IRA Traditional IRA Inherited IRA Required Minimum Distributions RMD

As the population in the U.S. ages, its becoming more common for people to inherit an individual retirement account (IRA) from their parents, aunts and uncles, or even a sibling or friend. However, it's important to follow the steps, outlined below, to the letter, or the small errors you make could prove to be expensive. While there may be several options available to you, regarding your inherited IRA, those options are dependent on factors such as your relationship with the original account holder, the age of the original account holder when they passed away and the type of IRA account you have inherited. Here are four critical steps you should follow to avoid expensive inherited IRA mistakes.

Step 1: Title the New IRA Correctly

The first step after you inherit an IRA is to correctly set up the title of your inherited IRA. If you skip this step, you will not be in a position to properly stretch the distributions. An inherited IRA should have the name of the deceased original owner, and it should also indicate that the IRA was inherited. However, it's important to note that the spouse of the deceased original owner does have the additional option to roll over the inherited IRA into an IRA account in their name. When setting up the inherited IRA, it's advised that you take the time to name your own beneficiary. If you pass on without emptying the inherited IRA your beneficiary will continue taking the distributions but according to the first beneficiary’s life expectancy.

Step 2: Calculating the Right Distribution Amount

The prior year-end account value and the life expectancy are needed to calculate the required minimum distribution (RMD) amount. For this calculation, the value of the account from the last year is used. For example, to calculate the distributions for the year 2018, the account value on 31st December 2017 is used. Life expectancy is also important, and the heir - if not a spouse - can use the Single Life Expectancy Table. However, it can be done only once, and every year after that the beneficiary will deduct one from the previous year’s factor, in order to calculate future required minimum distribution amounts.

Step 3: Determine If the IRA Has any After-Tax Basis

Most beneficiaries are either unaware, or they don't bother to find out of the IRA they just inherited has an after-tax basis or not. This mistake alone can prove quite expensive. If you have inherited an IRA and you find out that it has an after-tax contribution you should make an effort of filling in the Form 8606. Filling in this form allows you to claim the non-deductible portion of the required minimum distribution. You can ask the executor if they know if it has an after-tax contribution but they might not know and they have to check the tax returns of the deceased to find out if they filled the form in previous years. To be sure, you should do some research of the deceased's prior year tax returns.

Step 4: Make a Plan for the Taxation of Distributions

Taxation of distribution is different for Roth IRAs and other IRAs. With Roth IRAs, in most cases, the distributions are tax-free if the beneficiary is taking the required minimum distributions. However, for other IRAs, the distributions are fully taxable unless the original IRA owner had a tax basis on their IRA. You can refer to step three above to find out if the IRA had a tax basis. If the distribution is taxable, you should add the taxable portion of the distribution to your tax projection for the year to determine the proper amount of tax withholding.

To avoid making expensive mistakes, you should consult with a knowledgeable adviser as soon as you get a notification that you have inherited an IRA. A single mistake could mean that you lose your ability to retain the account's tax advantages while you stretch the payments. In addition, failure to take your required minimum distributions in a timely fashion could in a large large tax bill.


Disclosures:

  • This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.
  • This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Faithful Steward Wealth Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
  • Some information in this blog post is gleaned from third party sources, and while believed to be reliable, is not independently verified. The statements contained herein are based upon the opinions of Faithful Steward Wealth Advisors.