RSM Resources

In terms of dollar value, the most significant assets in an estate are typically residential real estate and one or more IRAs. While most heirs understand their options for buying, selling or transferring real estate, the Byzantine rules associated with being an IRA beneficiary can puzzle even well-informed, experienced investors.

The choices you make as an IRA beneficiary — in this case, we’re talking solely about traditional IRAs, with a note on Roth IRAs later — can affect not only your tax bill but your retirement-savings picture and that of your heirs. If you think you might be a prospective heir, or if you’re planning your own estate, here are a few fundamental things to know about inherited IRAs.

Naming beneficiaries matters

Heirs face a different set of options based on how — or whether — they are named on an IRA’s designated beneficiary form, as well as their relationship to the deceased account holder. An individual beneficiary has more options than an institutional beneficiary (such as a charity). Likewise, spouses have more options than do children or other beneficiaries.

Further complicating things, a designated beneficiary form listing multiple beneficiaries can pose strategic challenges for heirs. For instance, if a charity is named as the primary beneficiary and a child is named as a secondary beneficiary, the child may be forced to take a one-time distribution — and a big tax hit.

In general, the more specific the designated beneficiary form, the better. If an account holder didn’t complete a form, or if that form names only "my estate" or "my will" as beneficiary, the courts may have to get involved, costing heirs precious time, not to mention legal expenses. If you haven’t done so already, talk to your parents about their designated beneficiary forms, and make sure your own forms are up-to-date — including contingent beneficiaries. If you name multiple beneficiaries, be sure your choices are consistent with instructions in your will. When in doubt, consult your attorney and a tax professional.

Non spousal heirs face limited options

If you are the designated beneficiary of an IRA, but not the spouse of the original account holder, you aren’t allowed to treat the IRA as if it were your own. This means you can neither make contributions to the account nor roll over the account into your own IRA. Despite these restrictions, however, you do choose from several options as a nonspousal heir.

One option is to work with the financial institution managing the account to transfer the IRA to a beneficiary distribution account, also known as an inherited IRA, and then take the entire amount of the account in distribution. While this move can get you a windfall that is not subject to any early-withdrawal penalty, the distribution is subject to ordinary income taxes, so consult a professional.

Another option, which also first requires a transfer to an inherited IRA, is to begin taking a series of annual required minimum distributions over the course of your lifetime. The IRS’s life-expectancy table determines the size of these distributions. (The usual age 70-1/2 threshold for initiating distributions does not apply in this situation.) If you need access to more funds than the required minimum distribution, you can take a larger distribution. Again, each distribution from a traditional IRA is a taxable event, so stretching distributions over time can reduce your tax burden and leverage the inherited IRA as part of your own long-term financial plan.

Finally, if your own financial picture feels secure as is, another option available to you as a nonspousal beneficiary is to disclaim some or all of the inherited IRA’s assets. Instead, you can pass the assets on to contingent beneficiaries, such as your children,so long as they are listed on the original account holder’s designated beneficiary form. This move could protect the assets from taxes, if your children are in a lower tax bracket than you.

Spouses have two bonus options

It’s common for an IRA account holder to name his or her own spouse as the designated beneficiary of the account. In the event that the account holder dies, the heir has all of the options listed above, plus two more.

The first option unique to spouses is a "spousal rollover." In this scenario, the spouse works with the financial services provider managing the IRA, and the financial services provider managing the spouse’s own IRA, to complete the rollover. From that point forward, the spouse’s rollover IRA is subject to all of the same rules (annual required minimum distributions, early withdrawal penalties, and so on) it was previously.

A spousal rollover offers an heir several advantages. One is that the heir can continue to contribute to the account. A younger spouse can increase the potential for compounding interest by delaying any distributions until age 70-1/2.

The second option unique to spouses is to transfer the account into an inherited IRA, and then delay taking any distributions until age70-1/2, as with the rollover scenario. This option would appeal to younger spouses without pre-existing IRAs who are interested in maximizing their potential for compounding interest and delaying their tax obligations.

Time is of the essence

An important thing for beneficiaries of IRAs to understand is that time is your enemy. As far as the IRS is concerned, a clock begins ticking the day the original account holder dies, measuring the time elapsed toward several deadlines. Distributions from an inherited IRA, for instance,must begin by Dec. 31 of the year following the death of the original account holder. If you choose to take the entire amount of the account in distribution, you must do so by the fifth year following the death of the original account holder. There are several other related deadlines based on what you choose to do with the account. Your tax professional can help you avoid penalties.

Roths are a little different

All of the options discussed thus far apply to beneficiaries of both traditional and Roth IRAs. But the strategies associated with those options are very different because distributions from Roth IRAs come free of income tax. (The Roth account holder has already paid income tax on all contributions.) There are several other challenges unique to inheriting a Roth IRA, so again, work with your tax professional.