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Inherited IRAs; Be Very Careful How You Handle Them!


IRAs have proven to be excellent vehicles for retirement saving.  They also occasionally end up in someone’s estate following their death, and they then become someone’s  inherited IRAs.  This is an excellent way to pass benefits to heirs, but there are some fairly complicated IRS rules that must be followed if the benefits are to be maximized.  Let’s look at a few examples.

A spouse inherits the IRA

A surviving spouse who inherits an IRA has more flexibility than other beneficiaries.  They can choose to keep the account in the name of the deceased and remain the beneficiary.  They can then take minimum withdrawals based on their own life expectancy while the account balance continues to grow tax-deferred.  Note that beneficiary’s withdrawals are never subject to early-withdrawal penalties, regardless of his or her age.  This could be a good choice for a younger spouse who needs current income.  Another choice would be to transfer the balance of the inherited IRA into an IRA held in their own name.  As the owner they could then make additional contributions to the account and postpone taking any taxable withdrawals until they reached age 70 and ½ when required minimum distributions (RMD) would begin.  Of course if they withdraw any funds from an account in their own name prior to 59 and ½, a 10% early withdrawal penalty would apply.  And third, they could always simply withdraw the entire balance and pay the required taxes the year the balance was withdrawn.  This is seldom a wise choice.

A non-spouse inherits the IRA

If you inherit an IRA from anyone other than your spouse, a parent for example, you have to begin taking distributions by December 31 of the year after the original owner’s death.  You will remain the beneficiary and are allowed to stretch those yearly distributions, which are taxable of course, over your entire life expectancy (based on an IRS table); but you can never become the owner of the inherited IRA.  If you were to commingle the funds from an inherited IRA with an IRA owned in your name, you have just created a very expensive taxable event.  This you want to avoid!  To avoid a taxable event with the entire balance, you will need to transfer the assets into a beneficiary distribution account, also called a beneficial IRA.  It remains an IRA, with both your name on the account as beneficiary and the deceased person’s name as the original account holder.  Example:  “John Smith IRA (deceased September 12, 2009) for the benefit of Susan Smith, beneficiary.”

Insure that the financial institution does not put the IRA directly into your name, or cut you a check for the balance.  Again, either of those mistakes can result in that nasty taxable event. You may make a “custodian-to-custodian” transfer and move the account from, for example, Schwab to Vanguard, but do not allow the original custodian to issue you a check.  This is very important if you want to avoid that nasty tax bill.   Of course, you may cash out the account so it is no longer an IRA.  This makes all of the money income for you in the year you cash it out.

IRA owners should always designate a beneficiary (as well as contingent beneficiaries) for their IRA accounts.  Generally, the beneficiary should be an actual person rather than an estate or a trust.  (An exception could be made for a precisely worded trust for a minor or handicapped child.)  An IRA inherited through a will or a trust can become taxable much sooner and offer fewer options to those inheriting it.

Inherited IRAs are governed by very strict and complicated tax rules.  Failure to comply with these rules can greatly decrease the benefits that the original owner of the IRA would have surely wanted you to have.  Go slowly and insure that you understand all of the tax ramifications that come with an inherited IRA.

If you are having trouble sleeping some night, you can review all of the IRS rules for IRAs here:


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