If you are planning to leave your individual retirement account (IRA) to your kids or you are getting ready to inherit an IRA from a relative, you need to understand the inherited IRA rules to save them money on taxes.
Otherwise, one wrong move could cost you or your heirs a ton of cash and turn your gift into somewhat of a financial burden. Your goal is to pass along as much of the account as you can to your heirs, so you’ll want to set them up to pay as little in taxes as possible.
The best part of an IRA (like a 401k) is that it is a long-term tax shelter. This means that all the money you put into the account grows on a tax-deferred basis. This includes dividends, interest and capital gains.
If you have a traditional IRA, your heirs will have to pay income taxes on any amount they withdraw. They can easily determine the amount owed using a free online tax calc. If you have a Roth IRA, taxes will have already been paid on the money put into the account. In either situation, the best strategy for dealing with the inherited IRA rules is to keep as much money as you can in the account for as long as you can.
The more money that is in the account, the better it will be for whoever inherits your IRA in the future. The tax-sheltered growth of the mutual fund investments will probably continue to grow for many years to come. This is money that will likely be much-needed for retirement. The way in which IRA inheritances are handled depends on the type of heir. Here is a brief rundown of what you should know.
Inherited IRA Rules for Spouses:
This is the easiest type of IRA inheritance because the IRA can simply be transferred into the spouse’s name. This is known as “retitling” the IRA and is very simple to do. You can also choose to roll the funds in the original IRA into a new IRA in your name. When you roll the money over, it is done on a tax-free basis.
The withdrawal guidelines stay the same for the new owner of the IRA. If you leave the money in the IRA alone until you turn 70 and a half. At that point, you must start withdrawing funds from a traditional IRA but you won’t have an early-withdrawal penalty. If you have your money in a Roth IRA, you can leave the money in there for as long as you want.
Young spouses who need the money right away will be required to pay a 10 percent early-withdrawal fee until they reach the age of 59 and a half. If you retitle the account as an “inherited IRA”, though, you can avoid that penalty. The inherited IRA rules are very specific on this matter. You must retitle the IRA as your spouse’s name and date of death and “for the benefit of” your name, beneficiary. This will allow you to start withdrawing funds without incurring an early-withdrawal penalty.
Once you reach 59 and a half, though, you will want to retitle the account again, this time in your name only. This will allow you to keep the money in the account until you are 70 and a half. Otherwise, you would have to start taking withdrawals when your spouse would have turned 70 and a half. Depending on the age difference between you and your spouse, this could translate into a lot of money.
IRA Inheritance Rules for Children and Non-Spouses:
The IRS rules are completely different for inherited IRAs that are going to children or non-spouses of the original owner. You are not able to roll the balance of the account into an account in your name. In addition, you don’t want to cash it out because if it’s a traditional IRA, you will owe income taxes on the money. In addition, you will miss out on all the tax-sheltered money that an IRA can give you if you keep the money in it.
For this reason, you will want to retitle your account as an “inherited IRA”, just as you would if you were a spouse. Again, it should be retitled as your parent’s name and date of death and “for the benefit of” your name and “beneficiary.” In the event that the fund is going to be split between more than one child, each heir should retitle his or her portion. You will be required to take out a minimum amount of money each year based on how old you are; however, you can always take out more than the minimum if you need to. These withdrawals will be taxed, but the remaining balance will continue to grow tax-deferred.
The inherited IRA rules apply to any generation, so if an heir to an IRA passes away, the heir to the heir can receive the funds and continue withdrawing the money on the same schedule. In theory, an inherited IRA could be passed down for decades.
Re-titling is Critical!
The most important rule to inheriting an IRA that you need to know is that retitling the new account correctly is the key to saving as much money as possible. If you don’t retitle it according to the rules, you will end up paying taxes on the entire amount in the account. The lawyer that is in charge of the estate should be able to help you with retitling the account so you avoid this situation.
If you own an IRA, either a traditional or Roth account, you will want to leave explicit instructions in your will as to how to retitle the funds to make sure your heirs are protected. After all, you want them to receive as much money as possible from the account you leave to them.
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