Did you know that when you inherit a traditional IRA and you aren't the spouse of the account owner, then you'll most likely have several very different choices as to what to do with your inheritance? Unfortunately many IRA beneficiaries aren't aware of all of their options, and so they end up with a huge income tax bill. But in many situations income taxes can be minimized simply by understanding all of the options and then choosing the one that will result in the smallest income tax bill.
Below is the list of four options that you may be able to choose from when deciding what to do with your inherited traditional IRA. And please note that you will not be allowed to rollover the inherited IRA into your own IRA, this is simply not an option. However, you will be able to take distributions without paying the 10% penalty for early withdrawals.
By the way why, before getting into the actual list of options, why do I keep saying "you may be able to choose from" various options? Because not all IRA custodians offer all four options to the non-spouse beneficiaries of traditional IRAs. In addition, some of your choices may be limited due to the age of the account owner at the time of his or her death, and surviving spouses may have options that are very different from non-spouse beneficiaries. Thus, you must first ask the IRA custodian what specific options you have with regard to your inherited IRA before deciding what to do in your particular situation.
4 Options for Non-Spouse Beneficiaries of Inherited IRAs
Option #1 - Cash Out the IRA in 5 Years. You, as the non-spouse IRA beneficiary, will be able to withdraw all of the funds from the IRA by December 31 of the fifth year following the IRA account owner's death. If you choose this option, then each withdrawal will be included in your taxable income during the year the funds are withdrawn. You do not have to take the distributions in installments but must withdraw all of the funds at any time prior to the applicable December 31 date.
Option #2 - Take Out Required Minimum Distributions Over Your Life Expectancy. You, as the non-spouse IRA beneficiary, may be able to take required minimum distributions over your very own life expectancy, leaving the bulk of the account to continue to grow in a tax-deferred manner. This is often referred to as a "Stretch IRA." If you are significantly younger than the IRA account owner and you are able to choose this option, then you will potentially be able to create a nice little nest egg for yourself. With that said, you will also be able to take out more than your required minimum distribution in any given year if you need to do so. As with option #1, each distribution taken will be included in your taxable income during the year the funds are withdrawn. In order to choose this option, you must establish a separate inherited IRA account in the deceased account owner's name for your benefit and take your first required minimum distribution by December 31 of the year following the year of the account owner's death. For example, the inherited IRA account would be titled "John Doe, IRA (deceased 1/1/13), FBO Sally Doe, beneficiary." In addition, you should be able to name your own successor beneficiaries if you die and funds still remain in your inherited IRA.
Option #3 - Take Out Required Minimum Distributions Over the Oldest Beneficiary's Life Expectancy. You, as the non-spouse IRA beneficiary, may be able to take required minimum distributions over the life expectancy of the oldest beneficiary of the IRA. This will be the result if the IRA account owner named more than one beneficiary of their IRA and separate inherited IRA accounts are not established for each IRA beneficiary by December 31 of the year following the year of the account owner's death. As with options #1 and #2, each distribution taken will be included in your taxable income during the year the funds are withdrawn.
Option #4 - Cash Out the IRA Account Immediately. You, as the non-spouse IRA beneficiary, will be able to withdraw 100% of the account immediately and put the funds into your own pocket. If you choose this option, then 100% of the account will be included in your taxable income during the year of withdrawal. Since choosing this option may very well bump you into a higher income tax bracket, it will be important not to spend all of the funds during the year in which they are withdrawn and instead set aside enough funds to pay the income tax bill. Otherwise, you could find yourself in trouble with the IRS.
What Happens if You Do Nothing?
Mark December 31 of the year following the year of the IRA account owner's death on your calendar because you will need to decide what to do with your inherited IRA on or before this date. If you do not do anything by this date, then Option #1 listed above will become mandatory and you will be required to withdraw everything from the IRA account by the end of the fifth year following the year of the IRA account owner's death.
What Should You Do?
If you have inherited an IRA, then please, please do not ask the IRA custodian for advice about what to do with your inheritance, and please, please do not simply withdraw 100% of the funds as soon as possible. Instead, slow down, take a deep breath, and then consult with an estate planning attorney, a tax accountant, and a financial advisor in order to determine which option will work the best in your situation.