4 Steps to Take When You Inherit an IRA

As the population in the U.S. ages, it is common for people to inherit an individual retirement account from their parents, an aunt, or even a friend. However, it's important that the below steps be followed to the letter or the small errors one makes could prove to be expensive. There are several options on how you can handle the account, but it is dependent on some factors such as your relationship with the original account holder, the age of the original account holder when they passed away, and the type of account you inherited. Here are four crucial steps you should follow to avoid expensive mistakes.

Step 1: Title the New IRA

The first step after you inherit an IRA is to correctly set up the inherited IRA. If you skip this step, you will not be in a position to properly stretch the distributions. An inherited IRA should have the name of the deceased original owner, and it should also indicate that the IRA was inherited. However, the case is different when the deceased was a spouse because they can roll over the amount in the inherited IRA into their account. When setting up the inherited IRA, you are required to name your beneficiary. If you pass on without emptying the inherited IRA your beneficiary will continue taking the distributions but according to the first heir’s life expectancy.

Step 2: Calculating the Right Distribution Amount

The prior year-end account value and the life expectancy are needed to calculate the distribution amount. For this calculation, the value of the account from the last year is used. For example, to calculate the distributions for the year 2018, the account value on 31st December 2017 is used. Life expectancy is also important, and the heir if not a spouse can use the Single Life Expectancy Table. However, it can be done only once, and every year after that the heir can deduct one from the previous year’s factor.

Step 3: Determine If the IRA Has an After-Tax Basis

Most beneficiaries are either not aware, or they do not bother to find out of the IRA they just inherited has an after-tax basis or not. Such a single mistake can prove quite expensive in the future. If you have inherited an IRA and you find out that it has an after-tax contribution you should make an effort of filling in the Form 8606. Filling in this form is to kelp you claim the non-deductible portion of the required minimum distribution. You can ask the executor if they know if it has an after-tax contribution but they might not know and they have to check the tax returns of the deceased to find out if they filled the form in previous years. To be sure, you should do some research on prior year tax returns.

Step 4: Make a Plan for the Taxation of Distributions

Taxation of distribution is different for Roth IRAs and other IRAs. With Roth IRAs, in most cases, the distributions are tax-free if the beneficiary is taking the minimum distributions. However, for other IRAs, the distributions are fully taxable unless the original IRA owner had a tax basis on their IRA. You can refer to step three above to find out if the IRA had a tax basis. If the distribution is taxable, you can add the taxable portion of the distribution to the tax projection for the year to find out the amount of tax you should withhold.

To avoid making expensive mistakes, you should hire a knowledgeable adviser as soon as you get a notification that you are receiving an inheritance and have inherited an IRA. A single mistake could mean that you lose your ability to stretch the payments. A mistake could also get you stuck with a large tax bill on the amount you inherit.

About Angela

Angela Dorsey is the founder and financial advisor at Dorsey Wealth Management, a fee-only financial planning firm based in Torrance, California, helping women prepare for retirement. Angela earned a BS in computer science from Loyola Marymount University, an MBA from UCLA Anderson School of Management, and spent 20 years as a Senior Compensation Specialist in large corporations before becoming a CERTIFIED FINANCIAL PLANNER™ professional and a Registered Investment Advisor (RIA). That background gave her the tools to couple with her passion for empowering women to make the best financial decisions possible. Angela lives in Torrance, California, with her husband. She enjoys spending time at the beach or surrounded by nature. To learn more about Angela, connect with her on LinkedIn.

This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.