Don’t Lose Your IRA Inheritance to Taxes or Penalties

Have you recently inherited an IRA from a loved one, or do you think you will someday? If so, it’s important to understand your options for taking payments from that IRA, so you don’t lose your inheritance to taxes or penalties.

IRA owners receive a tax benefit for contributing to a traditional IRA and do not pay taxes on investment earnings while they remain in the IRA. These tax breaks are intended to encourage saving for retirement – with the caveat that the deferred taxes will be paid in the future. Now that you have inherited those tax-favored assets, you are responsible for taking the money out of the traditional IRA within a certain time frame – and paying income taxes on that money depending on your personal tax rate.* If you do not take payments on time, the IRS may assess a 50% penalty on the amount that was required to be taken but remained in the IRA.

You don’t have to take all the money – and the tax hit – at once though. You have options as to when and how much you take each year from your beneficiary IRA.

Possible Payment Options

The tax laws in the Internal Revenue Code define the minimum payment a beneficiary must take from an IRA. Most IRAs will allow you to take payments more rapidly than required under the tax laws.

The payment and timing options available to you depend on two variables:

Your relationship to the IRA owner – a spouse, a person who is not a spouse, or a non-person such as an estate or trust
Whether the IRA owner died before their “required beginning date” (explained below) for taking required minimum distributions (RMDs) or whether they died on or after that date.

Depending on your relationship to the IRA owner and his or her age at death, you may have some or all of these payment options available to you.

Five-year rule – You may take payments of any amount on any date as long as you deplete the entire IRA by December 31 of the fifth year following the IRA owner’s death. This may be a preferred option for those with an alternative investment that can appreciate significantly in the short term or that may take time to liquidate.

Life expectancy payments – You must take at least a minimum payment each year until the IRA is depleted. Payments are calculated using an IRS formula. Depending on your relationship to the IRA owner, you may be able to spread payments out over your lifetime. This is a popular option for beneficiaries who want to spread out the tax consequences of the inheritance.

Transfer or rollover – You can move your inherited IRA assets to another IRA custodian. If you were not married to the IRA owner, you must directly transfer the beneficiary IRA assets to another IRA set up as a beneficiary IRA, which has special rules as compared to other IRAs. A beneficiary IRA cannot accept any other contributions and must make distributions according to the beneficiary payment rules. There are no investment restrictions on beneficiary IRAs, however, so as long as the IRA contains enough liquid assets to pay out the minimum payment each year, a beneficiary IRA can be used to maintain alternative investments.

Timing of First Distribution

The deadline for taking your first distribution depends on your relationship to the IRA owner and his or her age. Generally, you will have until December 31 of the year following the year of the IRA owner’s death to decide which payment option you want to follow. If the IRA owner died on or after his or her required beginning date, however, you may be required to take a payment in the year of death.

Here’s how it works:

When an IRA owner attains age 70½ (six months past their 70th birthday), they must begin taking an annual RMD** from their traditional, SEP and SIMPLE IRAs.
Beginning with the 70½ year, an RMD must be taken each year until the IRA is depleted. But IRA owners have a little extra time to take their first RMD. They can delay the first payment until April 1 of the year following the year they reach age 70½. This April 1 date is referred to as the “required beginning date” (RBD). Whether an IRA owner dies before or after their RBD is a critical element of determining a beneficiary’s payment options.
If an IRA owner dies after their RBD and had not yet taken the RMD for the year, the beneficiary must take the RMD for that year. If there is more than one beneficiary for the IRA, the beneficiaries must split the RMD in amounts equal to the ownership rights they have in the IRA.

Next Steps

If you think you are the beneficiary of an IRA, bring a certified copy of the death certificate to the custodian holding the IRA as proof of the IRA owner’s death. The IRA custodian will locate the beneficiary designation on file to confirm the named beneficiaries. When the beneficiary determination has been made, depending on financial institution policy, the IRA custodian may set up a separate account for you in the system or request that you sign a beneficiary IRA application to establish an IRA in your name.

If you want to transfer inherited IRA assets to STRATA Trust, you can go to our Forms section to open a beneficiary IRA using our Online Account Opening feature or download the IRA account forms.
If you have questions about your beneficiary payment options, please contact us at 866-928-9394 or
Watch for future STRATA Trust blogs on beneficiary IRAs and payment options.

*The beneficiary payment options for SEP and SIMPLE IRAs are the same as for traditional IRAs. Roth IRAs follow slightly different rules.

**Custodians are not required to send RMD notifications on inherited IRAs. For more information, please see Section 3 of IRS Notice 2002-27.

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