Many mistakes are made with inherited individual retirement accounts (IRAs).
The rules aren’t straightforward or intuitive, so people often make the wrong decisions, resulting in thousands of dollars of taxes unnecessarily paid to the Internal Revenue Service (IRS).
Bottom line: Your loved ones need to know what to do when they inherit an IRA.
Knowing the rules is especially important for spouses. Most IRAs name the spouse as the primary beneficiary.
A surviving spouse has more options than other IRA beneficiaries. That provides more opportunities to maximize the after-tax value of the IRA, but it also increases the potential for choosing a bad option.
A surviving spouse who is named the beneficiary of his or her deceased spouse’s traditional IRA has the same options as any other IRA beneficiary. But there’s a twist to one of them, and the surviving spouse has an additional option.
Option #1 is to distribute all of the IRA assets within five years of the original IRA owner’s death.
Of course, that eliminates the potential for tax-deferred compounding of the IRA. All the distributions will be included in gross income and taxed in the same way they would have been to the original owner.
That’s the least attractive tax option, but might be considered when the cash is needed. One positive aspect of this option is that the 10% tax on distributions made before age 59½ don’t apply to distributions from inherited IRAs.
The penalty won’t be imposed, regardless of how young the surviving spouse is.
Option #2 is to establish an inherited IRA.
This involves changing the title of the IRA to reflect that it is an inherited IRA held for the benefit of the surviving spouse.
Each IRA custodian uses its own particular wording, but the title of an inherited IRA is typically similar to this:
Max Profits, deceased, IRA FBO Rosie Profits. (“FBO” means “for the benefit of.”)
Here’s one area in which the rules are a little different for a surviving spouse.
When non-spouse beneficiaries establish an inherited IRA, they are required to begin required minimum distributions (RMDs) by Dec. 31 of the year following the original IRA owner’s death.
No matter how young the beneficiary is, required distributions must begin and can be based on the beneficiary’s life expectancy.
The rule is the same for a surviving spouse if the deceased spouse already reached the age for required minimum distributions.
But the surviving spouse has an option when the other spouse passed away before reaching the required minimum distribution age.
The surviving spouse doesn’t have to begin required minimum distributions from the inherited IRA until after the deceased spouse would have been age 70½.
When the required minimum distributions begin, they are based on the surviving spouse’s life expectancy, not the deceased spouse’s — unless the surviving spouse wants to use the deceased spouse’s age.
Yet, the surviving spouse is permitted to take distributions from the IRA whenever money is needed before the RMDs begin.
The distributions will be taxed the same as they would have been for the original owner, but, because this is an inherited IRA, the 10% early distribution penalty doesn’t apply.
The options above are available only if the surviving spouse is the sole primary beneficiary of the IRA.
If others share as primary beneficiaries, then all are treated as non-spousal beneficiaries.
Option #3 (one that’s unique for surviving spouses) is the spousal rollover, or fresh start, IRA.
The surviving spouse can use this option for his or her share of an IRA even when there are other primary beneficiaries.
Under this option, the surviving spouse moves the assets to his or her own IRA.
The move can be done by the IRA custodians, or the surviving spouse can take a distribution and deposit that amount into his or her own IRA within 60 days.
The spousal IRA can be a new IRA set up for this purpose, or an existing IRA. The assets also can be moved tax-free to any other qualified retirement plan, such as a 401(k) account.
Once a spousal IRA is created, it is treated as though it has always been the surviving spouse’s IRA. No reference is made again to the inherited IRA.
The surviving spouse names new beneficiaries. The required minimum distributions schedule is determined solely by the surviving spouse’s age, not by the deceased spouse’s age. That’s why it’s also called a fresh start IRA.
Option #4 is very similar to the third option. The surviving spouse simply treats the inherited IRA as his or her own IRA.
This has the same effects as the spousal IRA, but it is rarely done this way. Usually, the spousal rollover is used.
That avoids any misunderstanding about the surviving spouse’s intentions. Once executed, a spousal rollover is irrevocable.
I’ve just given you four different scenarios to work off of.
Next week, I’ll show you how to figure out the BEST option for you. (HINT: it usually has to do with the spouse’s age.)
You can check out Part 2 of this post here.