By: Jack Knopoff (JKnopoff@BRP-CPAs.com)
A tax case just came across my desk indicating that an inherited IRA distribution from a taxpayer’s deceased mother’s IRA was determined to be taxable income. The daughter had attempted to rollover the IRA distribution into her IRA account; the tax code denies rollover treatment of an inherited IRA. If you recently inherited an individual retirement account (IRA) from someone other than your spouse, you may be wondering what to do with the funds in the IRA, and what the tax consequences are. There are certain rules you should be aware of relating to title transfers, distributions, and the taxation of funds in an IRA you have inherited. Negative tax consequences may result if certain rules are not followed. It is important to note that the rules discussed below apply only to nonspousal IRAs – different rules apply to IRAs inherited by a spouse.
Inherited IRAs. The rules governing inherited IRAs differ from the rules that govern IRAs bequested to a surviving spouse. Upon the death of an IRA owner, ownership of the IRA passes to a beneficiary or beneficiaries that the owner has designated in accordance with terms of IRA. If a beneficiary is not the owner’s surviving spouse, the IRA is treated as an inherited IRA.
Contributions and rollovers. Inherited IRAs cannot accept rollover contributions from other IRAs and, likewise, distributions from inherited IRAs cannot be rolled over. However, inherited IRA assets may be transferred in a direct, trustee-to-trustee transfer, as long as the IRA into which amounts are being moved is established and maintained in the name of the deceased IRA owner “for the benefit of” you as the beneficiary.
Required distributions. You generally will not have to pay federal income tax on the assets in the inherited IRA until you begin receiving distributions from the account. All inherited IRAs – whether a traditional or Roth IRA – are subject to annual required minimum distribution rules. The rules are complicated and you should talk with us before taking any distributions from the inherited IRA. The outline of the distribution rules that follow is just that, an “outline,” with details that may be crucial to some situations left out for the sake of brevity. In general, beneficiaries of inherited IRAs must receive required distributions over their life expectancy or within five years after the original IRA owner’s death. The rules can be tricky, and generally depend in part on whether the original IRA owner died before the date on which he or she was required to begin taking distributions from the IRA. The original account holder generally must gradually start taking out funds after reaching age 70 ½.
When an IRA owner dies before the date on which he or she is required to begin taking annual distributions from the traditional IRA, the entire IRA must generally be distributed in accordance with either the five-year rule, which requires that the entire interest be distributed within five years of the original owner’s death, or the life expectancy rule. The life expectancy rule requires that any part of the inherited IRA be distributed, beginning on or before December 31 immediately following the calendar year in which the original IRA owner died, over the life of the beneficiary (or over a period not extending beyond the life expectancy of the beneficiary).
If the individual for whom the IRA was maintained dies on or after his or her required beginning date, the remaining assets in the IRA must be distributed at least as rapidly as under the method of distribution being used as of the date of death. In general, the applicable distribution period is either the longer of the life expectancy of the designated beneficiary or of the IRA owner. Annual distributions are based on the beneficiary’s life expectancy using the beneficiary’s age in the year following the year of the IRA owner’s death.
For inherited Roth IRAs, all funds must be withdrawn within five years of inheriting the account.
Taking distributions from your inherited IRA over your life expectancy, as opposed to a lump sum distribution from the IRA, enables you to continue to grow the assets in the inherited IRA tax-deferred. A lump sum payment, however, may be requested but the amount may even put you in a higher tax bracket for the year. As you may have observed, these rules are complex but, nevertheless, decisions must be made.
Federal tax consequences. Distributions from inherited IRAs are taxable to the beneficiary as ordinary income. Beneficiaries of a traditional IRA must include in their gross income any taxable distributions they receive. If they do not withdraw a required distribution amount in any tax year, the amount is still subject to federal income tax but also is subject to a 10 percent penalty.
Federal estate tax deduction. You may be able to claim a deduction for estate tax resulting from certain distributions from an inherited IRA that is a traditional IRA. Under the tax law, a beneficiary of an inherited IRA may be able to deduct the estate tax paid on any part of a distribution that is “income in respect of a decedent.” We will discuss these rules and the tax consequences with you.
There are many other rules and tax consequences that result from inheriting an IRA. It is important that you talk with us immediately after inheriting an IRA in order to maximize the funds in the account and minimize negative tax consequences.
Jack Knopoff, CPA
Jack P. Knopoff is a partner of Bronswick Reicin Pollack, Ltd. – Certified Public Accountants and Business Advisors located in Buffalo Grove, IL. Bronswick Reicin Pollack has helped hundreds of businesses and organizations with their financial concerns. Visitwww.BRP-CPAs.com or call 847-808-9800.
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