As of late 2009, Americans held over $4 billion in individual retirement arrangements, better known as IRAs and Roth IRAs.
About 40% of American families have an IRA. (Numbers are from the Investment Company Institute.)
The older you get, the more likely you are to have an IRA. That’s because older people are wiser and because they roll their 401(k)s over to IRAs when they retire.
What am I getting at?
If you inherit money from a relative, there’s a good chance that most or all of that money will be in an IRA.
Because the rules about inherited IRAs are complicated, most people get confused and wind up paying enormous amounts of unnecessary taxes.
I don’t want this to happen to you, so file this column away, just in case.
You can put it in the file with the classic Ann Landers clippings Grandma sends you, so one day, when you’re remembering Grandma’s love of homespun advice, you can also remember to treat her IRA in a way that would have made her proud.
First, a quick recap of how your own traditional IRA works (we’ll get to Roth IRAs later).
When you contribute to a traditional IRA, you get a tax deduction.
Later, when you withdraw the money in retirement, you pay income tax on it. With a few exceptions, if you take money out before age 59.5, you also pay a 10% penalty on that withdrawal.
Now, let’s say you inherit Grandma’s IRA. The IRS still wants its share of the money. But you don’t have to pay all the tax at once, and that’s the mistake most people make.
When you turn the entire IRA into income and blast yourself into a higher tax bracket, you get stuck with an insane tax bill.
What NOT to do
Don’t do anything until you have a plan. Duh. Read on.
Don’t try to combine Grandma’s IRA with your own IRA. You’ll turn the whole inherited IRA into taxable income.
Don’t try to contribute money towards Grandma’s IRA. It’s not allowed.
If you want to move Grandma’s IRA to a different custodian, proceed with caution. A custodian is the investment company where an IRA lives.
Say Grandma kept her IRA with Vanguard but you prefer Schwab.
No problem: call Schwab, explain the situation, and tell them you want to make a trustee-to-trustee transfer. You will never personally touch the money.
If it were your own IRA, you could withdraw the money from Vanguard, deposit it at Schwab within 60 days, and pay no tax or penalty. That won’t work with Grandma’s IRA.
Don’t liquidate the whole account and go to Vegas. I mean, unless you’re one of those card-counting MIT students. And unless Grandma was into that sort of thing and it was her dying wish to see you blow it all in one weekend.
Little tiny withdrawals
To recap, you’re going have Grandma’s IRA transferred to your preferred custodian, if you like, but you’re not going to mix it with your own savings or withdraw the full amount yourself for any reason.
It’s fine to adjust the investment options inside the IRA at any time. Was grandma really into utility stocks but you’d prefer a more diversified portfolio? Go for it.
Here’s the last rule about inherited IRAs: you have to withdraw a little money from them every year.
The IRS calls this Required Minimum Distributions (RMDs).
If you inherit an IRA, you have to take RMDs based on your own age, not the age of the deceased. If you’re relatively young when you inherit the IRA, the RMDs will be tiny for many years.
If you fail to take them, you’ll pay a penalty. (There is no early withdrawal penalty on inherited IRAs, so you can withdraw as much as you want, but not less than the RMD.)
Your custodian can help you figure out the RMD, or you if you want to stay spry, like Grandma, try the mental workout known as IRS Publication 590.
Other common questions
That’s all you need to know about inheriting Grandma’s traditional IRA. Here are a couple of other scenarios you might be wondering about:
What if Grandma had a Roth IRA?
Withdrawals from Roth IRAs, as you know, are tax-free. Inherited Roth IRAs work like inherited traditional IRAs: no mixing, no new contributions, and you must take RMDs based on your own life expectancy.
You won’t pay any tax or penalty on withdrawals from Grandma’s Roth IRA, unless she established the account less than five years ago.
If she did, you’ll have to wait until the account is five years old.
What if Grandma and Grandpa each left me an IRA? Can I combine them?
What if I inherit an IRA from my spouse?
A special rule applies:
If you inherit your spouse’s IRA, you can go ahead and roll it into your own account and the money will be treated in every way as part of your own IRA.
If you do this, you’ll lose the ability to make early withdrawals without penalty, but you won’t have to take RMDs until you turn 70.5.
What if I inherit a 401(k)?
It mostly works the same way as inheriting an IRA. Check with an estate lawyer or certified financial planner for the details.
In fact, this is good advice if you inherit any significant amount of money.
Finally, this would be a good time to check the beneficiaries on your own retirement accounts.
Oh, and to answer another common question: no, you can’t leave an IRA to your cat.
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