Let’s be honest. Stress doesn’t help us make smart financial decisions. I think it’s fair to say when we are inheriting money it’s often a busy, hectic and stressful time in our lives. Here are a few mistakes you want to avoid if you inherit an IRA or other retirement accounts from a loved one. Don’t let these five mistakes destroy your loved one’s legacy.
Some retirement account mistakes can be fixed. On the other hand, if you make a mistake with an inherited IRA, it will be an extremely expensive lesson to learn. Likely, there will be no way to correct these mistakes or take the sting out of the sky-high cost from the tax man. Mistakes like these are most likely to happen when an IRA owner passes away and leaves his or her IRA to someone other than a spouse or a non-profit organization. In cases like these, we are talking about beneficiaries like a child, grandchild, sibling or just someone they really liked.
Let’s look at some of the most common, non-spouse IRA beneficiary errors.
Ineligible Inherited IRA Rollovers
If you are a non-spouse beneficiary, you are not allowed to do an indirect rollover. What exactly is an indirect rollover, you ask? This type of rollover takes place when the account holder transfers assets from one qualified retirement account to another. In this situation, the account holder is responsible for ensuring that the money is transferred from one account to another within a 60-day window. If more than 60 days pass from the withdrawal then taxes will be due on the distribution along with an early withdrawal penalty of 10% if the account holder is younger than 59 ½. Again, a spouse inheriting an IRA can also do this but a non-spouse beneficiary CANNOT do this type of rollover.
As a non-spouse IRA beneficiary, you are only allowed to do a direct transfer to a properly title Inherited IRA without being taxed. If you make the mistake of withdrawing the funds, they will be taxable, and the ability to create a stretch IRA will be lost. This potentially hugely expensive mistake cannot be reversed. The IRS has no ability to provide relief here. If inherited IRA funds are to be transferred or moved, the funds must be transferred directly between the two accounts without you ever having to take hold of the money.
Stretching the IRA allows you to make withdrawals over time. In essence this allows you to stretch the taxation over several years, thereby ideally lowering the overall taxes paid on your inheritance. At the same time, it gives you the ability to enjoy tax deferral for a longer period of time on the IRA account balance.
Not Titling the New Accounts Properly
How you title an Inherited IRA is more complicated than setting up a traditional IRA for yourself. The decedent must appear in the account title and it should also indicate that it is an inherited or beneficiary IRA. A titling sample might read “Rich Uncle (Deceased 2/25/2018), IRA, FBO Lucky Niece, Beneficiary.” Improper titling could result in mistakes with the account or you could get confused and treat it as your own IRA. These types of mistakes could nullify the entire Inherited IRA and result in a whopping tax bill. Picture the entire balance being taxable in a single year, on top of your regular income. Great for the IRS, terrible for your finances.
Contributing to an Inherited IRA
People are busy, get confused and send money to the wrong accounts. It happens. Remember, you cannot contribute to an Inherited IRA. Once this happens, it will no longer be considered an Inherited IRA. It will be treated as the beneficiary’s IRA and all of the inherited money will become taxable. Picture it: You inherit a million-dollar IRA. You are feeling flush and want to lower your own tax bill with say a $5,500 contribution to your personal IRA. Instead, the money is mistakenly deposited into your Inherited IRA. If your investment firm doesn’t catch the mistake, and I wouldn’t count on them to catch the mistake, you just voided your Inherited IRA and the entire $1,000,000 balance would become taxable. A mistake like this would push you into the highest tax brackets and could easily cost you $370,000 in federal taxes not to mention state taxes. OUCH.
Forgetting to Take Required Minimum Distribution
You might think, I’m in my forties so I don’t need to think about the Required Minimum Distribution (RMD). For your own retirement accounts, you would be correct. But the rules are different for Inherited IRAs.
RMDs on an Inherited IRA and an Inherited ROTH IRA generally begin in the year after the death of the original IRA owner. All the time I hear, “Someone told me I didn’t have to take money out until I was 70.5.” Because of this, people also assume the RMD requirement for Inherited ROTH IRAs are the same as non-inherited ROTH IRAs – sadly they are not.
Stretch IRA mistakes
To be eligible for a Stretch IRA you must be the designated beneficiary of a retirement account. This is the person who was actually named on the beneficiary form of the account. Not every non-spouse beneficiary will be able to do the Stretch IRA. If you ended up with the account via will, or some provision in the IRA custodial agreement when no beneficiary was expressly named – you will not have the option to take withdrawals over your full lifetime.
If you are the inheriting beneficiary through the estate, you will not necessarily be requited to take a lump sum. You may have options. The RMDSs will be based on when the original IRA owner passed away. If the decedent passed away before RMDs were required to begin (April 1st of the year after attaining age 70 ½), then the entire IRA would have to be paid out by the end of the fifth year after the decedent’s passing. This is often called the Five-Year rule. If the IRA owner dies after RMDs had begun, however, the beneficiary would need to take RMDs based on the IRA owner’s remaining life expectancy as if the decedent had not died.
Take a deep breath. These mistakes are common but with a little help are easily avoided. Take your time, double-check what you are doing and don’t be afraid to reach out for help. The costs are too high to risk a costly mistake, especially because they can’t be reversed. Work with your CPA and financial planner to make sure you are maximizing your windfall and minimizing your tax bill.
Live for today, plan for tomorrow.