Inherited IRA Rules: What You Need To Know

Deborah L Jacobs for Forbes writes: Many people who inherit IRAs are unfamiliar with the rules that apply to them. My article for Forbes magazine, “Five Rules For Inherited IRAs,” gives a broad overview of the subject. In this post I answer questions from two readers with concerns that affect other people, too.

Michael Twersky, a 26-year-old consultant in New York, asks:

I inherited a $15,000 traditional IRA from my father. As a child beneficiary, will I avoid income tax upon withdrawal if I wait until I’m 60? If not, would it be better to withdraw now while I’m still in a pretty low tax bracket?

You don’t have the option of waiting until you are 60 to take withdrawals. Generally, non-spousal IRA heirs must withdraw a minimum amount each year, starting by Dec. 31 of the year after the IRA owner died. Note: This is true whether it’s a traditional IRA or a Roth (a common misconception).

To calculate this distribution, you take the balance on Dec. 31 of the previous year and divide it by the inheritor’s life expectancy, as listed in the IRS’ “Single Life Expectancy” table. (You can find the table in IRS Publication 590, “Individual Retirement Arrangements (IRAs),” which downloads here as a PDF.) Unless the account is a Roth, there is income tax on this required payout.

Don’t make the mistake, as some people do, of using the number from the table to figure a percentage. In subsequent years, you simply take the number you used in the first year and reduce it by one before doing the division.

If they choose to, IRA inheritors can draw out these minimum required distributions over their own expected life spans, as explained here. This is known as the stretch-out – a financial strategy to extend the tax advantages of an IRA. Stretching out the IRA gives the funds extra years and potentially decades of income-tax deferred growth in a traditional IRA or tax-free growth in a Roth IRA. This is a wonderful investment opportunity.

A financial advisor in Overland Park, KS, asks:

My father-in-law, who lived in Missouri and died in October 2012, named my husband as the sole beneficiary of a $100,000 IRA. Sounds nice, but my mother-in law, 63, really needs the money. (She isn’t able to work and doesn’t have a lot of savings.) If my husband disclaims the IRA, does it automatically go to his mother? There are no contingent beneficiaries on the account and my father-in-law didn’t have a will. 

Disclaiming (turning down) an inheritance in a case like this one is a wonderful strategy, but your father-in-law’s failure to take basic estate planning steps might prevent your husband from disclaiming the whole thing.

People making disclaimers, known as disclaimants, are generally treated as if they had died before the person from whom they are inheriting. So the first question is: Who would be next in line to inherit?

Money in individual retirement accounts (or employer sponsored retirement plans, such as 401(k)s and 403(b)s) will not normally be covered by a will. Instead, an IRA inheritance is given out according to beneficiary designation forms that you fill out when you open the accounts or later amend. These forms notify the bank or financial institution (the custodian) about who will inherit your account. This is the beneficiary.

Since your father-in-law did not name an alternate beneficiary, it’s not clear from the form who is next in line to inherit. If your husband were to disclaim, it would be as if your father-in-law had not named a beneficiary at all.

When there is no beneficiary for an IRA, a default policy, spelled out in the custodial agreement, applies. And you’re at their mercy. Most default to the estate but some let it to go first to the spouse. So first find out what is the custodian’s policy. If it defaults to the spouse, your husband should be able to disclaim and have the assets to go to his mother.

If, on the other hand, it defaults to the estate, there is another complication since your father-in-law died without a will. While it’s true that retirement assets generally don’t pass according to the terms of the will, when there is no beneficiary designation form, the custodian might take the position that the IRA should go to the people named in the will.

If you die without a will or living trust (“intestate,” in legalese), state law will determine how most of your belongings are distributed. These laws establish a ranking of inheritors. Some newer laws say everything will go first to the spouse, then to children, parents and siblings. (See my post, “‘I Don’t Have An Estate. Why Do I Need An Estate Plan?’“) Missouri law is different, however. It says that if you die without a will, but leave behind a spouse and children, the spouse only gets 60%.

You can see this for yourself by going to the wonderful, free, interactive website, mystatewill.com. On the map of the United States at the top of the homepage, click on the abbreviation for your state–it includes all states (plus the District of Columbia) except Louisiana. Without asking for your name or any other identifying information, it steps you through a series of questions. Then it tells you what would happen if someone dies without a will.

But let’s hope you can work this out with the IRA custodian. Get past the person who answers the 800 phone number and ask to speak to the individual who oversees inherited IRAs. Then make the case for an equitable result as convincingly as you have above.