If you are a named beneficiary of an IRA, you inherit a designated portion of the IRA assets when the IRA owner dies. A common mistake, especially by non-spousal beneficiaries, is to withdraw all IRA assets from the IRA account after the IRA owner’s death; there is a much better way to handle it. Generally, you can have a new inherited IRA account created, and have your share of the deceased owner’s IRA proceeds transferred directly into it. It is important that this is done correctly, and if done so, the benefits can be enormous.
The focus of this post is on non-spousal beneficiaries. Spousal beneficiaries have more options than discussed here, such as treating the inherited IRA as their own, or rolling it over into their own IRA.
With a properly-created, non-spousal, inherited IRA account, you have the option to withdraw only a portion of the inherited IRA each year (there is a minimum amount that you must withdraw, depending on your age), but you retain the option of withdrawing as much as you want at any time. Taking only the Required Minimum Distribution (RMD) each year allows the majority of the IRA to continue to grow tax-deferred for a traditional IRA, or tax-free for a Roth IRA. For a traditional IRA, this also allows you to spread the tax payments over many years, rather than paying all the tax in one year. With a large enough traditional IRA, withdrawing it all at once can generate a large tax bill, possibly pushing you into higher tax brackets, resulting in quite a shock when you prepare your tax return for that year.
As a named beneficiary, it’s up to you to inform the deceased owner’s IRA custodian (financial institution) that you wish to have an inherited IRA account created, and to make sure that the proper procedures are followed. Large financial institutions like Vanguard, Fidelity and Schwab have standard procedures and forms to transfer a deceased owner’s IRA assets into a properly-titled inherited IRA account. It’s easier if you have the new inherited IRA account created at the same financial institution, but it’s not necessary. If you choose a different custodian for the new inherited IRA account, you must have the proceeds transferred directly from the current custodian to the new custodian (a trustee-to-trustee transfer).
I have experience with inherited IRAs at Vanguard and Schwab, so can personally attest to their efficient handling of the process. However, some financial institutions may not know how to do this correctly, so you must make sure you get appropriate guidance. If any mistakes are made, you lose the opportunity to spread the distributions and payment of any taxes over many years. IRS Publication 590 includes details on the rules for inherited IRAs
An inherited IRA account is separate from any other IRA accounts you may have. You cannot make contributions to an inherited IRA account. The withdrawal rules are different for inherited IRA accounts; generally you must begin taking distributions from an inherited IRA in the calendar year following the year of the IRA owner’s death, both for traditional and Roth inherited IRAs, regardless of your age.
While on the topic of inherited IRAs, another important point is that the IRA owner should ensure that there are properly documented, up to date beneficiary designations. Normally you designate beneficiaries when you first create your IRA, but perhaps your relationships have changed since since then, or for some other reason your current wishes about who you want to inherit your IRA are different; don’t forget to update your IRA beneficiaries!
Also, it’s generally not a good idea to name a trust as the IRA beneficiary, as it complicates the inheritance process, and may limit the ability of the beneficiaries to stretch the distributions over many years. It’s even worse to name your estate as a beneficiary, or not to name any beneficiaries.
Creating inherited IRA accounts for multiple beneficiaries is not a problem if there are named, individual beneficiaries (i.e., as opposed to an estate or trust as beneficiary). Upon the IRA owner’s death, an inherited IRA can be created for each designated beneficiary, and the IRA proceeds transferred according to the IRA beneficiary designations.
As a simple example, if the IRA owner has named two children as beneficiaries, each to receive 50%, then upon the IRA owner’s death, the IRA custodian can create an inherited IRA for each child, and transfer half of the deceased owner’s IRA assets into each new inherited IRA account. Each inherited IRA account must be properly titled to indicate that it’s an inherited IRA. Again, it’s up to you to instruct the IRA custodian to do this, and to make sure it’s done properly.
Inherited IRAs can be used to stretch the distribution of IRA assets over many years, and even over multiple generations. This is sometimes referred to as a stretch IRA; you can read more about the stretch IRA concept in the Investopedia article, What is the "stretch IRA" concept?.
Don’t make one of the mistakes discussed above, and blow the opportunity for you or your heirs to take advantage of stretch IRA techniques. To summarize, the mistakes are:
- Failing to properly designate beneficiaries for your IRA account
- Withdrawing the assets from the IRA account after the owner’s death
- Failing to follow the proper procedures to create the inherited IRA account and transfer the assets into it