Did you know that when you inherit an IRA you can limit your income tax liability by deciding how distributions are made to you? Unfortunately, many IRA beneficiaries don’t know they have options and so they cash in their inherited IRA and expose themselves to significant income tax liabilities. The options available to IRA beneficiaries vary depending on if the beneficiary is a spouse or non-spouse, so this article will focus on the three distribution options non-spouse IRA beneficiaries typically have to limit their tax liabilities. Not all distribution options work best for every situation, so IRA beneficiaries are encouraged to consult with their CPA and attorney to find out which option works best for them.
Option 1: Rollover IRA with Five Year Distribution
If an IRA owner dies and designates a non-spouse beneficiary, such as a child, parent, sibling, or friend, the beneficiary can choose to rollover the IRA into their name, but the entire IRA must be distributed to the beneficiary within five years of December 31 of the year following the IRA owner’s date of death. This option gives the non-spouse beneficiary access to money relatively soon and spreads out the tax liability over a five year period, rather than in one year if a lump sum distribution is taken.
Option 2: Stretch IRA
The second option for a non-spouse beneficiary is a stretch IRA. With a stretch IRA, the non-spouse beneficiary receives the IRA’s annual required minimum distributions (RMD) over the beneficiary’s remaining life expectancy. The beneficiary’s remaining life expectancy is determined by the beneficiary’s age in the calendar year following the year of death and reevaluated each year. For example, if the IRA owner dies and his 50-year-old daughter is the sole beneficiary, the daughter may choose to stretch out the IRA over her remaining life expectancy and will only receive the RMD each year. Beneficiaries who elect this option are only responsible for paying income taxes on the RMD they receive each year. This option has more favorable tax rules but limits the amount of money available to the beneficiary on an annual basis.
Beneficiaries who choose a stretch IRA need to be aware that ownership of the IRA must stay in the decedent-owner’s name, for the benefit of the beneficiary. If the beneficiary has already transferred the IRA ownership into their name, the IRA will be subject to the IRA Rollover rules over a 5 year period.
Option 3: Lump Sum Distribution
A non-spouse beneficiary also has the option to completely cash in the IRA and take a lump sum distribution. The beneficiary will be responsible for paying income taxes on the distribution in the year the distribution is made. This option gives the beneficiary immediate access to money but can potentially subject the IRA income to higher tax rates.
The IRA distribution rules and options for a non-spouse beneficiary are complicated. If you are the beneficiary of an inherited IRA, meet with your CPA or tax attorney to decide what option will work the best minimize your taxes.
Bill Hesch is a CPA, PFS (Personal Financial Specialist), and attorney licensed in Ohio and Kentucky who helps clients with their financial and estate planning. He also practices elder law, corporate law, Medicaid planning, tax law, and probate in the Greater Cincinnati and Northern Kentucky areas. His practice area includes Hamilton County, Butler County, Warren County, and Clermont County in Ohio, and Campbell County, Kenton County, and Boone County in Kentucky.
(Legal Disclaimer: Bill Hesch submits this blog to provide general information about the firm and its services. Information in this blog is not intended as legal advice, and any person receiving information on this page should not act on it without consulting professional legal counsel. While at times Bill Hesch may render an opinion, Bill Hesch does not offer legal advice through this blog. Bill Hesch does not enter into an attorney-client relationship with any online reader via online contact.)