How to make the most of an inherited retirement account

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As the number of defined benefit pension plans continues to fall, the value of assets in defined contribution plans like 401(k)s and IRAs continues to rise.  In fact, according to the most recent Federal Reserve System Survey of Consumer Finances report, Americans have nearly $12 trillion stashed away in retirement accounts.  As the usage of these plans has increased, so has the likelihood of inheriting an account from a friend or loved one.  While inheriting an IRA can prove financially beneficial, there are many complexities to consider before moving forward.  Since rules may vary depending on the relationship age of the deceased, it is important to understand the pros and cons of each alternative as missteps could prove costly.

Spousal options:  Rollover to own IRA

Spouses have more options than non-spouse beneficiaries when it comes to inheriting retirement accounts.  The first option is for the spousal beneficiary to roll the funds to their own IRA account.  This will allow the beneficiary to delay Required Minimum Distributions (RMDs) until they reach age 70 ½.  Additionally, the beneficiary’s life expectancy is the determining factor when handling future RMD calculations.  While this approach has its advantages, spousal beneficiaries under age 59 ½ that may need the access to the money should pause prior to taking this approach.  Keep in mind, pre-mature distributions from your traditional IRA (before age 59 ½) will be taxable and subject to a 10% early withdrawal penalty, even if you inherited the funds.  Spouses younger than 59 ½ may want to consider the next alternative.

Spouse & non-spouse beneficiary - Rollover to an inherited IRA

So what should a spouse do when they need distributions from IRA assets they inherit and need to avoid a 10% penalty?  Rolling the account to a beneficial or inherited IRA may provide the flexibility needed in a situation like this.  In this case, RMDs will be taken annually based upon the life expectancy of the beneficiary with distributions avoiding the 10% penalty.  Additionally, distributions greater than the RMD may be taken while still avoiding early withdrawal penalties.  Inherited IRAs can be a fantastic tool for spousal beneficiaries that need income today to help support their lifestyle. Remember, inherited IRAs must be established with RMDs taken by December 31 of the year following the date of death.  It is also important to note that unlike IRAs, inherited IRAs are not protected in the event of bankruptcy.

Rolling funds to an inherited IRA is an option also available to non-spouse beneficiaries.  Just like a spousal beneficiary, a non-spouse beneficiary can rollover the funds to an inherited IRA and take RMDs based upon their life expectancy each year.  Often referred to as a stretch IRA, this may allow the funds to growth tax deferred over the lifetime of the beneficiary.  The continued tax deferral can be powerful, especially if the inherited IRA is a Roth IRA.

Spouse & non-spouse beneficiary:  5 year rule

If the original account holder was younger than 70 ½ when they passed, the 5 year rule may be an option.  It allows distributions to occur at any time up until 12/31 of the fifth year after the death of the original account holder, as long as the account is fully withdrawn by then.  While taxes are owed on each distribution, there is no 10 percent early withdrawal penalty.  This only allows for 5 years of continued tax deferred growth and can result in a hefty tax bill – so be careful.

Spouse & non-spouse beneficiary: Refuse it

In the event that a spouse or non-spouse beneficiary does not want to inherit an IRA, they can choose to disclaim the asset or refuse to receive it.  Why wouldn’t someone want to receive an inheritance?  In some cases, a spouse may want assets to pass directly to a child and disclaiming assets can be a way to make that happen.  This may allow for an IRA to be distributed over a longer period of time based upon the beneficiary’s younger age.  Be sure to speak to your tax and legal advisers prior to implementing such a strategy as there are many factors to consider.

Spouse & non-spouse beneficiary:  Lump sum

Taking a lump sum distribution can be expensive, often leading to significant taxes.  Remember, distributions from an inherited traditional IRA are fully taxable as ordinary income.  On the other hand, distributions from Roth IRAs may not be as costly since the accounts may be distributed tax free.  Regardless, it is important to carefully review your options before liquidating an inherited IRA.  Tax deferred growth can be a game-changer for the beneficiary and the benefits of allowing funds to remain invested over the long-term should be considered before choosing to liquidate an inherited IRA.

Keep an eye on required minimum distributions

Whether you inherit a traditional IRA or a Roth IRA, placing funds in an inherited account require that distributions to be taken annually.  If the original owner of the account was younger than 70 ½ when they passed, distributions are due by December 31 of the year following their passing.  Alternatively, if the original owner was older than age 70 ½, you may also have to make a withdrawal in the year of their passing to satisfy the RMD they should have taken.  Also remember, the penalty for missing an RMD is 50 percent of required distribution amount

Also keep in mind that the number of beneficiaries can impact the calculation of RMDs.  If all beneficiaries open their own inherited IRA by December 31 of the year following the original owner’s death, each can use their own life expectancy to calculate RMD amounts.  In the event that the account wasn’t properly divided, you must use the oldest beneficiary’s age to determine the RMD amount for all the beneficiaries that were named.

If inheriting an IRA sounds complex, it can be.  However, proper planning and the help of a financial team can help beneficiaries make the most of their inherited accounts.  Consider reviewing IRS Publication 590-A for additional information.  Since everyone’s situation is unique, consider speaking to your tax, legal and financial adviser to determine the most appropriate approach for you.

Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor.  He can be reached for questions at 732-280-7550,, & LPL Financial Member FINRA/SIPC.