Inherited IRA - Avoid Tax Problems When Inheriting an IRA

Inheriting an IRA often comes at a time when we are under duress and more likely to make a quick decision just to get it over with. Be sure to make the intelligent choices about the distribution of an inherited IRA. Here’s a look at some things to keep in mind.

How to Protect Your Inherited IRA From the IRS
By Robert B Scott

At the end of 2008, Americans had over 14 Trillion [1] dollars stashed away in retirement accounts. This is a massive amount of money that has been growing tax deferred for over 35 years in some cases. As the baby boom generation begins to reach life expectancy, the amount of money that will be transferred to the next generation will be staggering. If you are going to be the beneficiary of an IRA or retirement account, you should be aware of some important details.

Here are some of the common and financially devastating mistakes made by heirs that you can avoid.

1. Failure to speak with the current owner about any planning they may have done to minimize taxation of the account when you inherit it.

Any planning the current owner may have done should always be discussed before death so you can talk openly about any ideas that could reduce taxes on the account as it is spent down. IRA planning can be complex and even a simple mistake can cost a fortune not just in tax today but in future income that is forfeited as a result of any rapid action vacant of thought.

Cashing out the IRA in a “lump sum”

It is common for an adult beneficiary to simply convert inherited accounts to cash and reinvest them with their own financial advisor. This can be IRA suicide if your current advisor has no real understanding of IRS publication 590 and the pitfalls involved with this type of transaction. What could have been an account that pays you for the rest of your life with continued tax deferral becomes an IOU to the IRS at rates as high as 35% depending on your tax bracket before and after the income is received. IRA money is received as ordinary income and taxed at your highest marginal rate. A $100,000 account cashed in at once could result in an IRS bill of $35,000. If that same account was “stretched” over your life expectancy, a 40 year old could recover over $400,000 in payments before the account has been spent down. (6% return used)

Failure to split the account into separate accounts

If there are multiple beneficiaries, it is best to split the Inherited IRA into separate accounts for each named beneficiary. This must be done on a timely basis to prevent distribution on a faster basis that could increase the tax bill. Miss the deadlines and you will not be able to stretch out the distributions over your life expectancy. This causes the loss of potentially thousands of dollars of tax deferred growth.

Failure to take a Required Minimum Distribution

According to IRS rules, a beneficiary of an inherited IRA is required to take a minimum distribution. The life expectancy used depends on your status as a designated beneficiary or not. Failure to take your RMD (Required Minimum distribution) on a timely basis could result in an IRS penalty of 50% of the RMD. [2]

Failure to Pick the Right Custodian

In 2001, Congress made it easier to calculate distributions from IRA accounts. The new rules also made it easier for IRA beneficiaries to eliminate lump sum taxes that ate away up to 80% of the IRA value after beneficiaries paid Federal Income taxes, estate taxes, and state inheritance taxes. Many custodians have expressed a desire to remain passive with regard to administration of the Stretch IRA due to potential lack of information on the beneficiary. Before deciding to keep your IRA with your current custodian, consider writing them a letter asking if they will allow you to have multiple beneficiaries and restrict how much can be taken out each year. One well known custodian made a policy change that potentially affected 170,000 customers. They wanted IRA owners to name the same beneficiary for all their IRA accounts of the same type [3] unless you directed them otherwise. Failure to read the mailed notice and respond would cause all IRA dollars in these accounts to pay out to one beneficiary and may have cut out all other beneficiaries. I see a fight coming with this one. Other custodians simply do not allow much flexibility in their beneficiary forms and suggest clients get a trust. This solution creates separate problems including but not limited to higher cost, and higher tax rates to heirs.

Most of these pitfalls can be avoided by seeking the help of a competent advisor familiar with publication 590 and IRA rules. An IRA review would be a wise investment to make sure these potential concerns are eliminated. Best wishes in preserving your inheritance.

[1] Investment Company Institute Research- 2009 Investment Company Factbook
[2] IRS Publication 590
[3] Forbes -Disinherited by Vanguard, September 3, 2007, p.68

Robert B. Scott is a financial representative with National Financial Services Group in Nashville, TN. He specializes in Insurance, Tax Reduction, and Retirement Planning. He can be reached at or at 800-228-3454

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