Even though the majority of Americans are worried about the possibility of outliving their retirement money, passing away with a still-loaded IRA could cause its own set of headaches for your heirs.
Whether you’ve recently become the beneficiary of a loved one’s IRA, or are planning ahead in case your retirement account outlives you, here’s what you need to know about inheriting an IRA.
The Benefits of Marriage
IRA inheritance is one of many instances when the benefits for spouses are much better than they are for any other beneficiary. The surviving spouse is entitled to something known as a spousal rollover. That means that the money can be rolled over into an IRA in the surviving spouse’s own name.
From that point onward, those assets will be treated exactly the same as any other retirement assets in the surviving spouse’s name. Because of this, it is the surviving spouse’s age that’ll determine things like early-withdrawal penalties and required minimum distributions.
However, for beneficiaries who are not married to the deceased, things get a little more complicated.
Rules for Non-Spousal Beneficiaries
There are two main options for all other beneficiaries. The first rule (and default) is that beneficiaries must withdraw the whole balance of the account by the end of the fifth year after the original IRA account holder’s death. It’s important to remember, however, that the IRS will still want to take their cut of the assets, since the money went into the account pre-tax. This can cause a potentially enormous tax burden for heirs, as they’ll have to declare the IRA balance as income in the year that they withdraw it.
The second — and financially savvier — option available to non-spousal heirs is to stretch out distributions from the inherited IRA over a lifetime. This option, commonly referred to as a Stretch IRA, allows a beneficiary to withdraw a minimum amount each year, potentially for the rest of their life. Much like the required minimum distribution that an original IRA account holder could take upon reaching retirement, these minimum distributions for Stretch IRAs are calculated based on the age and life expectancy of the beneficiary.
The real benefit of stretching out an IRA’s distributions is that it allows the balance of the account to remain in place and continue to grow, making the original inheritance much larger through time and compound interest.
It’s important to note that heirs who opt for the Stretch IRA may take more than the required minimum each year — they’ll just have to pay the additional taxes.
In order to take advantage of this option, heirs must begin taking the required minimum distribution as of December 31st of the year after the original account holder’s death. Miss that deadline, and you’ll be stuck taking the five-year liquidation option.
The Bottom Line
Both heirs and account holders would do well to set up a meeting with a certified financial planner to make sure that they’re taking advantage of their assets. A professional can help an account holder double-check that all paperwork is in order and that their money will be disbursed as intended. And heirs can get great advice on what to do and when — which is doubly important in a time of grief.
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