How to Inherit an IRA
Here’s a topic I’m sure to never face - inheriting an IRA. But for those people who might find it of some use, here’s a run-down on how to inherit an IRA.
Step 1: Have a relative wealthy enough to leave money to you.
Step 2: Help that relative set up an IRA naming you as beneficiary.
Step 3: Wait until relative dies.
Step 4: Decide what to do with inherited IRA.
Inherited IRAs really fall into two categories - spousal and non-spousal. Non-spouses can take all the cash out of the IRA immediately, establish a beneficiary IRA and begin taking annual distributions, or wait up to five years and then take the lump sum. Spouses have the additional option of making the IRA their own.
Cash-out option. Any beneficiary can use the cash-out option. This simply involves taking a lump sum and paying the tax on it as ordinary income.
Establish a beneficiary IRA. Going this route means taking annual distributions. The IRS publishes tables with life expectancy based on sex and age. Your annual distribution is based on how much longer the IRS says you’ll live. Since the IRS is always right, these tables come in handy for all sorts of things. I myself base my borrowing decisions on them. I try to arrange repayment beginning the year after the IRS says I’ll die. At any time, you can also take a lump sum.
Deferral cash-out. You can also do nothing for up to five years, then take the lump sum.
Roll-over option (spouses only). Spouses have the additional option of rolling over the IRA into one with their name. This also allows them to continue making contributions. Using this option, the spouse doesn’t have to begin distributions right away. Deferring taxes is nearly always preferable to paying them right now, so this is most likely the smartest move for the surviving spouse.
ira taxes
October 4th, 2007 at 9:05 am
Good post. Thought I’d add a comment about Stretch IRAs. I’m an estate planning attorney we sometimes recommend this as a tool for clients with larger traditional IRA accounts> It requires some number crunching based upon how much compounding the account is receiving and how much the annual distributions are, but in some cases it can be a great tool for continuing to grow and compound the account while also continuing to defer some of the taxes. Here is an excerpt from a memo discussing stretch IRAs:
A “stretch” IRA is not a specific type of IRA account, but rather, is a method of extending the duration of beneficiary distributions, thus permitting the assets in the IRA to continue growing tax-deferred. If you anticipate that you will not need your IRA distributions to support you during retirement, you may want to consider taking the required minimum distributions (RMD), with the goal of growing the remaining IRA assets for your heirs. Under the current law with respect to IRAs, the utilization of trusts with an IRA can provide an effective planning tool to create a tax deferral that allows subsequent generations to accumulate large amounts in retirement funds.
Under the current law, a traditional IRA participant is required to begin taking RMD beginning April 1 of the year following the year in which he or she reaches age 70 ½. Upon the death of the account holder, the RMD is based upon the life expectancy of the beneficiary. Thus, the younger the beneficiary, the smaller the RMD and the longer the assets will remain in the IRA compounding tax-deferred.
For example, if you invested $2,000 per year in an IRA from the age of 29 until your hypothetical death at age 69, after 40 years of compounding at an average rate of 7% your IRA would be worth $399,270. If you left the IRA to your younger spouse who had an additional 20 years of compounding before dying, the IRA would then be worth more than $1.5 million. If your granddaughter then became beneficiary and the account compounded for an additional 70 years at 7%, when she retired, the value of the account could be worth over $176 million.
October 4th, 2007 at 3:18 pm
October 13th, 2007 at 7:54 pm
Think about it this way, since the RMD formula (right now) is like 1/(83-beneficiary age), if you inherit an IRA that’s making roughly 8%, you’re not going to have to touch the principal until you’re 71 (1/12th). In my case, I inherited $150k in 2003 at age 26. Yes, I’d rather have my dad around, but that’s not a choice we can make. Anyway, I only have to take 1/53rd (1.8%) of the amount out this year. The account’s now worth $190k.
Two points:
First, you can only pass YOUR IRA to a person not your spouse ONE time. In other words, my dad’s IRA is still his IRA, with his name on it. I got it from him beccause he was divorced, but even if I got it after my mom died, when I die, the lump sum MUST be taken out by whoever I have designated as my beneficiary. So if you can trust your descendants to do the right thing, leave it to your youngest living descendant (grandkid).
Second, in the example JB talks about above, that $176 million figure certainly stands out. But even if you pretend that you’re 69 today and have spent 40 years putting $2000 in your IRA and have $399k in your account, that $176 million won’t be realized until 90 years from now, which means it won’t be nearly as dramatic a sum. Some things cost 100 times what they did 90 years ago, which means that $176 mil in 2097 dollars might only be $1.76 million in 2007 dollars. My point is that the money might be better spent somewhere along the way, especially if someone needs it.