As more and more pensions have phased out, individuals have become increasingly reliant on other retirement savings vehicles, like a 401(k) or an IRA. We hear a lot about people not saving enough for retirement, but for those that do, it's likely they will end up passing their unspent savings to younger generations. This can leave the individual inheriting these accounts in tax situations they haven't come across before. While there are many options for transfers and distributions you have to make sure that you avoid making any mistakes that could lead to costly tax consequences.
How are inherited IRAs taxed?
For the most part, inherited IRAs are taxed the same way they are by the original owner. As money is withdrawn from an inherited IRA it is taxed at the individual's income tax rate. Roth IRAs are withdrawn tax-free, the same as if the original owner had withdrawn them. A key difference however, is that the 10% early withdrawal penalty is waived. So even if you are under the early retirement distribution age of 59 1/2, you can withdraw money out of the inherited IRA without having to be worried about getting slapped with a penalty.
Mind the RMDs
As many retirees know, after they turn 70 1/2 they must begin taking required distributions from their Traditional IRAs (not Roth IRAs). The amount withdrawn is based on an IRS table that determines an aged based divisor which is used to calculate your first RMD (apply divisor to IRA year-end balance). The older you get, the higher percentage that needs to be taken from the IRA.
There are a few key differences for inherited IRAs. First, regardless of age, required distributions are mandatory. The divisor that determines the amount is also tied to your age and the rule applies that the younger you are, the smaller percentage that is required to be taken. A key difference is that these distributions apply to all IRAs, including Roth IRAs. For help calculating the distribution amount, it is best to speak with a financial advisor or accountant.
You also have to ensure that you take RMDs from both the inherited IRAs and Roth IRAs in the year after the original account owner died. Failure to take RMDs can subject you to a 50% penalty of the amount that was supposed to be distributed.
If you do make a mistake with past RMDs, make these RMDs as quickly as possible. If you aren't sure what the RMD amounts are, consult with a financial advisor or CPA. You can then submit a request to the IRS for a waiver of the 50% penalty. Being proactive is better than waiting to get caught by the IRS.
One thing to be mindful of when transferring inherited IRAs from one financial institution to another is that if you withdraw money from the account, it cannot be redeposited. Owners of IRA accounts (non-inherited) have the ability to withdraw funds once every rolling 12 months, and as long as it is redeposited in another like account within 60 days it is considered a rollover and not taxable. This exception does not apply to inherited IRAs and once the money is taken out, it's taxable.
Taking large unintended withdrawals can push you into a higher tax bracket. If taken from a Roth IRA, no taxes would be owed, but the opportunity for continued tax-free growth is lost. When deciding to take distributions from an inherited IRA account it's a good idea to consult with a financial advisor or CPA to discuss the tax impact on the withdrawal.
The good news is that inherited IRAs can be moved from one financial institution to another, they just have to go directly. For instance, if you have an account at Fidelity and wanted to move to Vanguard, this can be done by completing a transfer of assets request. That way the funds move from one account to the other without ever actually leaving the IRA.
A spouse is allowed to move an inherited IRA to their own IRA, and thus, will be subject to the same rules as their current IRA. If they are under age 59 1/2 and there is any chance they might need the money before age 59 1/2, they should setup an inherited IRA instead of rolling it into their own IRA, so they can avoid a penalty on withdrawals. There are no required minimum distributions for a spousal inherited IRA until the decedent would have reached age 70 1/2. For a spouse who inherits an IRA, it's a good idea to speak with a fee-only financial advisor to get fiduciary advice about your options