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Inheriting an IRA

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CFP_Cathie2If you are listed as a beneficiary on someone’s IRA, it is possible you will inherit that IRA if the owner passes before you. What to do with that inherited IRA often requires a decision process that is not easy to navigate given the IRS rules surrounding IRA distributions. Over the years we have seen inherited IRAs that have not been handled correctly by other advisors. We are fine being on the clean-up crew, but prefer to be on the front end when the decision matrix is critical.

Specifically, we are talking about inheriting an IRA where you are not the spouse of the deceased owner, but perhaps the child or sibling or another relationship. Although there are some interesting strategies we have employed with an inherited spousal IRA, which is another topic. An inherited IRA is basically an IRA that remains in the name of the deceased for the benefit of you/the beneficiary. This allows you to continue the tax deferred status, thereby stretching out the IRA, thus the nickname stretch IRA. The stretch comes from not requiring you to distribute 100% of the IRA as a taxable event within the first 5 years of death. Instead, you take required minimum distributions (RMDs) over your lifetime based on very specific IRS rules.

We recently assisted a client who inherited an IRA approximately five years ago. The IRA was correctly rolled into an inherited IRA in her name. However, she was mistakenly told by that financial advisor that she would have to cash out the entire IRA within 5 years. She came to us suspicious of that advice. Instead, she should have been advised that she take RMDs starting the year following the year of her dad’s death. To save the IRA, she is taking all 5 years of distributions this year. The distributions are tricky to calculate as they follow a different formula than the RMDs for those over age 70 1/2.  In addition, the excise penalty for failing to take an RMD is 50% of the required amount. A hefty penalty for sure, but better than cashing the entire IRA and paying the taxes in one year. Her tax advisor is planning to ask for a penalty waiver with the IRS. This is not the first time we have come across this mistake with clients, actually we have rescued three of these so far this year. It is interesting to note that even paying the penalty is likely worth saving the IRA tax deferred status.

Inherited IRAs are complex, but stretching out the tax deferral is almost always worth the extra hassle. We know the distribution rules and have the experience with inherited IRAs to guide clients through the decision process. We frequently calculate these RMDs for our clients and work with their tax advisor to properly administer the distributions. The important concept here is to recognize that you need to make decisions in a timely manner if you inherit an IRA and we are available to help.

Cathie Straub, CPA, CFP®
Director, APCM Wealth Management for Individuals

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