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YOU'VE INHERITED AN IRA
The starting point for this Tax Bulletin was a complaint made by a one or another of the newspaper tax advisers to the effect that the U.S. Treasury and the I.R.S. had not issued rules and regulations for telling taxpayers what you can or need to do with an inherited IRA (Individual Retirement Account). This is not true -- the rules and regulations have been available for several years. The problem is that they are very difficult to understand even after you find them. I am going to go over the most basic of the rules in this Tax Bulletin.
For purposes of this discussion, let us assume that you or a friend of yours who is asking you for advise (Rick or Suzy), has "inherited" an IRA from Uncle Jack. The question is, what must you do and what can you do and what are the tax consequences. This discussion will not cover the consequences of a participant spouse inheriting an IRA from a participant. That would require a discussion at least as long as this one with completely different set of rules.
One thing to note: for purposes of this discussion, it does not matter whether you have a traditional IRA or a Roth IRA -- you will need to start distributions with both after the death of the participant. The difference between a traditional IRA and a Roth IRA is that, under current tax law, distributions from the traditional IRA will be taxable to the recipient but not so with a Roth IRA.
As contrasted to most other forms of property, we know first off that there is a 99% probability that the IRA account was not given to you or your friend during Uncle Jack's life. Although one might speak of inheriting a house by gift, that is not so with an IRA. Because an IRA can only belong to the participant who established it, or his or her designated beneficiary (to be discussed later). So if a participant gives his or her IRA away, this is treated as a distribution to the participant and then the gift of cash and or securities to the donee. So, if you have inherited an IRA by gift, you just have a gift of cash and securities. If it is a gift of securities, your tax basis is the same as the donor's which, is the value at the date of distribution from the IRA.
O.K., let's assume that you did inherit the IRA at death. Next question -- were you a designated beneficiary? As part of the process of setting up the IRA, the participant lists who will get the IRA after he or she dies. As long as the beneficiary is a natural person (e.g. a human being) or certain kinds of trusts so that the trust really just stands for a natural person in the process, then that beneficiary is a designated beneficiary. Two common kinds of beneficiaries are not designed beneficiaries -- charities and estates.
The participant can change the names of the designated beneficiaries as often as his or her administrator lets him or her. You do not need to have just one beneficiary, and some of them can be contingent. You can set up the designation so that the IRA goes to your wife if she is alive when you die, or if she is not, then one third to each of your three children. You can also have multiple IRA accounts, and have different designated beneficiaries for the different accounts.
The next question is whether the participant had reached his or her required beginning date for making at least annual period distributions, namely the April 1 following the year in which the participant turned 70 1/2. If he or she had, and you or a trust for your benefit is a designated beneficiary, then the rule is simple--you now have an IRA that is titled say, Jack Smith IRA for the benefit of Rick or Suzy. You start taking distributions (very probably small distributions) in the year following your uncle's death over your life using tables supplied by the IRS. Most brokerage firms can handle this part.
Two parts of the above scheme are important:
(1) the IRA stays Uncle Jack's IRA. A spouse can take her husband's
IRA and make it her own, but not anyone else. If a non-spouse
does it, then it is treated as a complete distribution of the
IRA.
(2) If you do not take the minimum required distributions based
on your life expectancy, then you would be subject to a 50% penalty
based on the amount that you should have taken out but you will
still be allowed to continue to spread the payments out over your
life.
If the participant had not reached his or her required beginning date, then either you can make an election to take out the funds from the IRA over your life (basically the same as if the participant had reached his or her required beginning date), or if this election is not made and actually started no later the December 31 of the year following the participant's death, then the entire amount of the IRA must be taken out within five years of the December 31 of the year of the participant's death. You do not need to take the balance of the IRA in the fifth year, it just needs to be taken out no later than the end of the fifth year. Otherwise you would be subject to the 50% penalty for not making a required distribution.
If you are the beneficiary of a trust which was a designated beneficiary, then it is possible, if the tax planning and drafting where correctly done, that you will be able to spread the minimum distributions over your life, or the life of the oldest beneficiary, if there is more than one.
If however, there was no designated beneficiary or the estate was the designated beneficiary, then the result depends on whether the participant had reached his or her "required beginning date," and whether his or her life expectancy was being recalculated each year in determining the required minimum distribution. If the participant had not reached his or her required beginning date, then the IRA distributions must be completed by the end of the fifth year following the death of the participant (sounds familiar). If the participant had reached his or her required beginning date, then if the participant's life expectancy was not being recalculated, which is not the default and needs to be specially elected at the required beginning date, then the distributions would simply continue on the schedule that they had been prior to death. If the participant's life expectancy was being recalculated, which is the normal way, since his or her life expectancy goes to zero at death, then the entire balance in the IRA would need to be distributed in the year following the participant's death.
As I think you can see, these are very complicated rules and if you do inherit an IRA, then you need to be able to get the answers to several person and esoteric questions from the participant's personal representative, e.g. executor, trustee) as well as the administrator of the IRA. Hopefully someone would have kept a copy of the information that you need to figure out what you can and need to do.
Copyright Eleanor S. Hansen 1999
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