What happens to a Traditional IRA when the owner has passed and a non-spouse is inheriting? A non-spouse beneficiary has two choices.
One choice is to take a lump-sum distribution. In this case, even if you, as the beneficiary, are under age 59 ½, the 10% early withdrawal penalty is waived. To do this, you would need to transfer the assets into an account in your name, and then distribute the assets in a lump sum. All the funds are distributed at once, and all applicable income taxes will be due at once. Depending on the size of the assets, this option may put you into a higher tax bracket for the year of the distribution.
Another option is to transfer the assets into an inherited IRA, also called a beneficiary IRA. With this option, the assets can continue to grow tax deferred, and you will be able to designate your own beneficiaries. You would need to transfer the assets into a beneficiary IRA held in your name.
Distributions can be taken at any time, but are subject to required minimum distributions (RMDs). (The early withdrawal penalty waiver also applies.) RMDs are taxable and included in your gross income for the year. Your own life expectancy is used to calculate RMDs. Generally, RMDs must begin by December 31 of the year after the original owner’s death. However, there are a couple of caveats.
The first caveat is that if the original owner was over age 70 ½ and had not taken his/her RMD in the year of death, then that RMD is due for distribution in the year of death still, or penalties apply. The penalty for failure to take RMDs on schedule is 50% of the amount of RMD not taken.
In the second caveat, if the original owner was under age 70 ½, you as the beneficiary also have the option of delaying distributions – i.e., not taking RMDs on schedule without penalty. With this option however, all the assets must be distributed by December 31 of the fifth year after the original owner’s death. So in short, in the second caveat, if you take RMDs on schedule, you can stretch out distributions over your life expectancy. If you delay, all assets must be distributed within 5 years.
If you are sharing the inheritance with others, then you would need to establish separate accounts for each beneficiary by December 31 of the year following the year of the original owner’s death in order to use your own life expectancy. If you miss this date, the RMDs will be based on the life expectancy of the oldest beneficiary, which, if it isn’t you, will result in a higher RMD amount.
Sonja Gonzalez – Financial Planner