Personal Finance

How to make sure that inherited IRA doesn't cost you big time

Key Points
  • Inherited IRAs follow a different set of rules, particularly for those other than spouses of the deceased.
  • Investors should understand what they can and cannot do before making a move they will regret.
  • You need to make any required withdrawals before Dec. 31.
Jamie Grill | Getty Images

Someone close to you has died and left you money from an individual retirement account. Planning for this should be easy, right? Wrong.

The rules for inherited IRAs are complicated. Recipients are susceptible to making egregious mistakes when handling these accounts, which are subject to different rules than your own traditional IRA.

By comparison, those who inherit IRAs via a spouse have more choices, according to the IRS. For example, they can treat the inherited IRA as their own and add their name to it as the account owner. They could also roll it over into another traditional IRA. Or, they can consider themselves a beneficiary.

It took his father 40 years to build it and it took him 40 minutes to blow it.
Ed Slott
founder, Ed Slott and Co

The rules for inherited IRAs for individuals other than spouses are more rigid. The biggest difference is that other beneficiaries can never treat the IRA as their own. They cannot contribute to the account or transfer money in and out of it, according to the IRS.

An individual will not owe taxes on money in an inherited IRA until distributions are taken.

But beware: Inherited IRAs are like eggs, and once they're broken, you can't put them back together, according to IRA expert Ed Slott, founder of Ed Slott and Co.

"The people who inherit are never as careful with the money as the one who earned it," Slott said. "It's a little different when you spend your lifetime earning the money."

Here are the top mistakes financial professionals have seen investors make:

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Three retirement myths debunked

Touching the money before you know the rules

Slott still remembers what happened to one client's account when the client died in the late 1990s. The client, who earned a modest salary, managed to accumulate about $600,000 in his IRA. When he died, his son, who was not a client of Slott's, decided his father had invested too conservatively. The son withdrew the money with the intention of investing it elsewhere. What he didn't anticipate was the $250,000 tax bill he just incurred.

That is because inheritors are taxed on distributions from inherited IRAs. Take out all of the money at once and you will be taxed.

"It took his father 40 years to build it and it took him 40 minutes to blow it," Slott said. "He could have stretched that $600,000 over his life expectancy over 30, 40 years."

Not properly setting up an inherited IRA account

An inherited IRA must be created from the existing IRA, and not doing so the correct way can cost you.

"If mom leaves you an IRA, it's not your IRA [and] you can't put it in your own name," Slott said. "If you put it in your own name, it's taxable."

In addition to not putting the money in your own IRA, beneficiaries cannot roll the money into a Roth IRA, either, because Roths are funded with post-tax dollars. And inherited Roth IRAs are subject their own special set of rules.

Instead, inheritors should make a trustee-to-trustee transfer to ensure the funds are not erroneously distributed to them.

A properly established inherited IRA account should include the name of the deceased in its title along with the beneficiary. In his ebook on IRAs, Leon LaBrecque, CEO of LJPR Financial Advisors, cites the following example: "John Smith, IRA (deceased December 16th, 2014) FBO John Smith Jr., beneficiary."

Signs it's time to convert your IRA
Signs it's time to convert your IRA

Not taking required minimum distributions

Investors often inherit IRAs at a time when they are not thinking about retirement, LaBrecque said. Consequently, they can miss the rules for taking required withdrawals or RMDs, which they must do by Dec. 31 every year.

"When you inherit an IRA, you have to take a required minimum distribution or take the money out within five years," LaBrecque said. "You can always take out a little more, but you have to take that out."

If the inheritor fails to withdraw those funds, a custodian can turn to them after five years and make them take out all of the assets, resulting in a higher tax penalty, according to LaBrecque, who said he saw that very situation happen to a friend.

That bad outcome generally depends on the custodian, and the specific rules of your plan. IRS rules require individuals to pay a penalty for not having taken out the RMDs on time.

Not knowing the rules for stretching the funds

In many cases, IRA beneficiaries can arrange things so that the money lasts over a long period of time by taking out RMDs based on their life expectancy. But the same does not go for their own heirs.

Say a mother dies and leaves her IRA to her son. Then when the son dies, he leaves the money to his children. The children will not be able to extend their use of the funds based on their own life expectancy, though they can continue their father's stretch.

"Leave them to the grandkids because the stretch is way longer," LaBrecque suggested.

As more people inherit these accounts, they need to educate themselves and consult experts, according to Richard L. Bergen, president of RLB Wealth Planning Inc.

"You have to really study the rules and make sure you're following what needs to be done," Bergen said.

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