In general, IRAs were meant to help individuals save for retirement. Investors would contribute pre-tax to the account during their working years and then reap the benefits of the money saved in retirement, potentially when they are in a lower tax bracket. IRAs are unique in that should an account owner die, the assets pass by beneficiary designation, not according to a Will or probate. Often when an account owner is widowed or single, he or she will name a child, grandchild or other family member, as the beneficiary of the account.
The good news is that distributions from a non-spouse inherited IRA are not subject to the 10% early withdrawal penalty, regardless of the age of the beneficiary. However, if the funds are not withdrawn from the account within an IRS approved timetable, the funds could be subject to a 50% federal penalty tax. In all withdrawal methods, the beneficiary will owe ordinary income tax on the withdrawn assets to the extent that the distribution represents pre-tax or tax-deductible contributions and investment earnings. If you inherit a Roth IRA, distributions are not taxable, provided that the five-year holding period has been met, otherwise only earnings are taxable.
As a non-spouse beneficiary of a traditional IRA, one of the most ill-advised options is to withdraw the funds in a lump sum. While you will have complete control to do what you wish with your new-found fortune, you may end up facing a hefty income tax bill. The withdrawal is reported as ordinary income; therefore, any substantial withdrawal could bump you into a higher tax bracket.
Other withdrawal methods require you to transfer assets to an Inherited IRA account in your name. You cannot roll the assets into your own traditional or Roth IRA. You then have the option to deplete the IRA within five years of the original IRA owner’s death. This method would allow the assets to continue to grow tax-deferred for up to five years. Again, by choosing the five-year option, you as the beneficiary, could be bumped into a higher tax bracket depending on the size of the withdrawals.
Generally, the most recommended option is to use the life expectancy method because it often results in the smallest withdrawal, minimizing the tax consequences for the beneficiary and maximizing the time the assets can continue to grow tax deferred. With this method, mandatory withdrawals are calculated each year using the IRS’s single life expectancy table and the beneficiary’s age. Younger beneficiaries will enjoy a longer payout period under this method because of their longer life expectancies. You can always choose to withdraw more than the required amount at any given time, paying ordinary income tax on the withdrawal. However, if you fail to begin withdrawals under this method on a timely basis, the five-year withdrawal method will become the default option and you will not be permitted to use the life expectancy method.
If the original account owner was older than 70 ½ when he died, the beneficiary can opt to take withdrawals over the life expectancy of the account owner rather than their own life expectancy. This option is often better if the deceased IRA owner was younger than the beneficiary.
Because the penalty for not withdrawing in a timely fashion can be onerous, it is highly recommended that you consult a financial adviser or C.P.A. to assist you. The experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
