Minimizing Tax Penalties of Inheriting an IRA from a Non-Spouse

When a non-spouse leaves you a traditional individual retirement account (IRA), there are some tricky steps and options that must be followed. One wrong decision with the inherited funds can lead to immediate and expensive consequences, and it can be next to impossible to persuade the IRS to give you a do-over.

The worst thing to do is to cash out the plan, put it in an account and then ask your advisor “Now what?”  At that point, the ship has sailed and you could be in for a hefty tax bill.  So what can you do to lessen the pain?

Options for Liquidating IRA Fund

The money in an inherited traditional IRA must be taken out eventually, but there are a few options for liquidating the funds over a period of time.

Stretch Option
First, the non-spouse beneficiary can choose to take the distributions over their life expectancy, known as the “stretch option.” The stretch IRA allows a younger IRA owner to shelter funds from taxation while watching those funds grow over the years.

Five-Year Rule
Second, the non-spouse beneficiary can liquidate the funds under a five-year rule. This is the default option if the stretch IRA is not chosen. However, this option is not available if the account holder was already over age 70 ½. Then the distribution must be either a lump sum or over the life expectancy of the owner.

Plans are not required to offer these payout options. A plan can mandate either a lump sum payout or the five-year rule. In those cases, rolling the assets into an inherited IRA may permit a longer distribution period.

When to Take Required Minimum Distributions

Non-spouse beneficiaries shouldn’t procrastinate. In order to choose the stretch option, a beneficiary must take yearly required minimum distributions (RMDs) based on their own life expectancy.  There is a cutoff date for taking the first withdrawal. The first distribution must be made by December 31st of the calendar year following the year the owner died.  If you miss that date, you default back to the five-year rule.

The takeaway:  Don’t rush to make any decisions, but be wary that time is running out. In fact, the “stretch option” may not last too much longer. The Senate Finance Committee has recently supported a bill that would end the stretch option for non-spousal inherited IRAs. Stay tuned for any updates on this proposed change.

RMD Requirements

Year of death RMD requirements need to be considered if the deceased was age 70 ½ or older. If the owner of the inherited traditional IRA had not yet taken their RMD in the year of death, the beneficiary has to take it out by the end of the year of death. This can be tricky.  Let’s say your elderly uncle dies on January 24th, leaving you his traditional IRA.  He probably had not taken his RMD yet.  The beneficiary (you) should have ample time to make that distribution by the end of the year.

What if your uncle passes away on December 27th and had not taken his RMD for the year yet?  Even worse, you don’t realize you are the beneficiary until early the next year?  The year of death distribution requirement is subject to a 50 percent penalty.  However, the beneficiary may be able to request a waiver of this penalty if they can show that the shortfall was due to a reasonable error and steps are being taken to remedy the shortfall.

With planning and caution, the inherited IRA tax bite can be lessened and spread out over a period of years.  If you, have recently inherited any retirement funds and have questions, please contact an Anders advisor.