Non-Spouse Beneficiaries and Inherited IRAs

Understanding tax liabilities and complex rules when inheriting an IRA, especially for a non-spouse, can be daunting. Don’t hesitate to ask for help: mistakes can be costly.

People respond in a variety of different ways when receiving an inheritance from a loved one. Sometimes grief is mixed with excitement over the possibilities presented by the inherited assets, and this is not unusual, according to WTOP in a recent article, “Inherited IRA rules that non-spouse beneficiaries need to know.”

Depending on the amount of money and your level of wealth, the effect of receiving an inheritance can be a minor change in your tax liability or a notable change in your lifestyle. When looking at your options for an inherited IRA, it is important to recall that the tax rules differ depending on whether the beneficiary is a spouse or a non-spouse. For non-spouse beneficiaries like children or grandchildren, you need to understand the rules to avoid paying substantially higher income taxes and to keep more of your inheritance.

To simplify the decision-making process, we’ll look at selling the assets and taking a lump sum withdrawal or keeping the account invested.

Take a lump sum. A windfall inheritance may allow you to make a large purchase like a home or to take your dream vacation.  However, before you decide to cash in some or all your inheritance, consider the income tax implications and the risk of comingling your inheritance. Withdrawals from an IRA account—whether an inherited IRA or a regular IRA—are taxed as ordinary income in the year of withdrawal. Consider this if you plan to liquidate your entire inherited IRA account, because the value of the assets will increase your taxable income in the year that you sell the assets and take the funds.

If you decide to take a distribution from your inherited IRA, decide where to deposit the cash proceeds. If you’re married, segregate money in an account titled in your own individual name, which will help to protect your inheritance in the event of a divorce. Typically, when inherited funds are comingled into a jointly held account, they become marital property.

Invest the inheritance. To avoid the immediate tax burden triggered by a lump sum withdrawal from the inherited IRA, or if you don’t need the money now, keep the assets invested, so the inheritance can continue to grow tax free.  However, there will be mandatory distributions from the account over time. Talk to an attorney about the annual required minimum distributions, because the rules are complicated and are affected by factors such as your age, number of account beneficiaries and the age of the deceased.

If you decide to keep the inherited IRA invested, be certain that it’s titled correctly and designate your own beneficiaries. The IRS has strict rules on how to title an inherited IRA, and if disregarded in the estate settlement, your inheritance could become fully taxable, or your minimum distributions might be determined based on the life expectancy of the oldest beneficiary. Either way, your personal taxes will be impacted, thereby decreasing your total net inheritance.

Once you establish a segregated account for your inherited IRA, be sure to complete a beneficiary designation form for the account. You should first speak with your estate attorney because your beneficiary designation decisions can have tax and estate planning ramifications.

An inheritance is a gift, at the same time that the loss of a loved one that led to the inheritance is cause for sorrow. If your inheritance includes a non-spousal IRA, be mindful of these rules so that you don’t lose a substantial part of the gift, whether to enjoy it yourself or to pass it along to the next generation.

Reference: WTOP (June 14, 2017) “Inherited IRA rules that non-spouse beneficiaries need to know.”