As the population in the U.S. grows older, it is becoming increasingly common for individuals to inherit retirement accounts from their family members or friends. However, it’s important that as an heir to such accounts you follow particular steps in order to avoid making costly mistakes.
There are several options to handling inherited accounts, which depend on a variety of factors including your relationship to the original account holder, the age of the original account holder when he or she passed away and the type of account you’ve inherited. Here are four crucial steps to follow to increase your benefits in the long run:
Step 1: Title the New IRA
Once you inherit an IRA, you’ll want to make sure it’s set up correctly. An inherited IRA should have the name of the deceased original owner and it should also indicate that the IRA was inherited. Alternatively, if the deceased was your spouse, you have the option to roll over the amount of the inherited IRA into your own IRA account.
If you’ve inherited an IRA from someone other than a spouse, you will not be able to move money into your own retirement account. In order to keep the tax benefits of the inherited account, you will need to set up a new Inherited IRA for Benefit under your name.1 After the account has been created, you’ll be able to transfer assets from the original account to your beneficiary IRA.
Step 2: Calculating the Right Distribution Amount
If you’re a spouse of the deceased, the prior year-end account value and life expectancy are needed to calculate the distribution amount on your inherited IRA. For this calculation, the value of the account from the last year is used. For example, in order to calculate distributions for the year 2021 the account value on December 31, 2020, is used.
If you are a non-spousal beneficiary, it’s important to note that you’ll be required to withdraw the entirety of the account within 10 years, if the deceased passed on or after January 1, 2020.2 Prior to the SECURE Act passing, the IRA amount was allowed to be withdrawn throughout the beneficiary’s remaining life expectancy.
Step 3: Determine if the IRA Has an After-Tax Basis
Most beneficiaries are either unaware or unwilling to find out if the IRA they’ve inherited has an after-tax basis. If you have inherited an IRA and you find out that it has an after-tax contribution you should fill out a Form 8606.3 By completing this form you’ll be able to claim the non-deductible portion of the required minimum distribution.
You can always ask the executor if they are aware whether the IRA has an after-tax contribution, but they might not know themselves and will need to refer to the tax returns of the deceased to learn if they filled out the form previously.
Step 4: Make a Plan for the Taxation of Distributions
Taxation of distribution is different for Roth IRAs and other IRAs. In many cases, Roth IRAs have distributions that are tax-free if the beneficiary is taking the minimum distributions (based on pre-SECURE Act rules). However, for other IRAs, the distributions are fully taxable unless the original IRA owner had a tax basis in their IRA. If the distribution is taxable, you can add the taxable portion of the distribution to your own tax projection for the year to estimate the amount of tax you should withhold from any distributions.
As you make a plan for distribution, remember the SECURE Act’s new change for non-spousal beneficiaries. You will be required to distribute the entirety of the account within 10 years of inheriting it. Exceptions to this rule include:
Disabled or chronically ill persons
Minors (until they reach the age of majority)
Those who are less than 10 years younger than the deceased3
To avoid making costly errors, you should meet with a knowledgeable advisor as soon as you learn that you have inherited an IRA. Mistakes could mean larger taxes and complexities in the long run. Give us a call if you’d like to discuss your own situation.
Daniel is a Partner in the Houston office with over 20 years experience as a financial advisor. As a member of the firm’s Wealth Management practice, he is responsible for delivering investment and planning services to clients. He is committed to helping clients develop holistic financial plans to achieve personal and financial objectives.
Prior to joining Cerity Partners, Daniel was a Principal at Investec Wealth Strategies. Prior to joining Investec in 2003, Daniel started his career as a financial advisor with Prudential Securities in California.
Daniel received his BBA from the University of Texas in Austin. He is a CERTIFIED FINANCIAL PLANNER™ professional and holds the Certified Investment Management Analyst® (CIMA®) certification.
To give back to the community, he currently serves on the Board of Trustees and Finance Committee of The Shlenker School and recently served on the Board of Trustees for the Jewish Federation of Greater Houston. Daniel is also active in his children’s sports leagues where he coaches both their baseball and softball teams.