Guiding Clients Through An Inherited IRA

Older Baby Boomers are reaching the end of their lifespans, leaving their children and grandchildren poised to receive the largest collective inheritance in human history. Because Boomers were prodigious savers, much of this inheritance will come in the form of inherited IRA accounts. A very special set of rules apply to IRA beneficiaries. Understanding these rules is essential for accountants who will assume the task of guiding clients through inheritance management.

Relationships Matter

Your client’s relationship to the person who left them the IRA is one of the most important distinctions in IRA rules. There are different rules for spouses vs non-spouse beneficiaries. If the survivor is a spouse, the account is simply treated as if it is their own. They can contribute or withdraw to the account and treat it as their own in every way. All of the normal rules and restrictions apply.

However, the situation becomes more complicated for non spouse beneficiaries. To begin with, new contributions are not allowed. Rules are also more complicated for withdrawing funds. The new IRA owner must take all of the funds in a lump sum, either immediately or within five years of the death, or set up annual withdrawals based on their projected life expectancy. The tax advantages of an IRA account cannot be reaped for multiple lifetimes.

Choosing the Right Withdrawal Timeline

Whether the IRA beneficiary is inheriting a Roth or Traditional IRA, stretching out withdrawals is usually the best option. This allows the funds inherited as IRA assets to continue accruing without taxes for a longer time period. However, this may not be the case for every unique situation. Some clients are better served by taking a lump sum. Good accounting analysis is essential to making the correct recommendation.

Avoiding the Tax Man?

The rules for inherited IRA accounts will differ according to the type of IRA that has been inherited. In a Roth IRA account, withdrawals are tax free as long as they are being withdrawn in the first five years after the death of the original IRA owner. The only exception is if the account was made less than five years before it was inherited, in which case the earnings are taxable.

If the beneficiary has inherited a traditional IRA, the withdrawn funds will be taxable as normal taxable income. This can have a huge impact on a client’s finances and tax situation. There are rare exceptions, such as when the original contributions were non deductible and taxes were already paid on the funds. These are very unusual cases.

Althouvh withdrawing from IRA accounts before age 59 1/2 usually comes with tax penalties, this is not the case for an inherited IRA. Non spouse beneficiaries can withdraw without the 10% IRS penalty. In fact, it is advantageous to withdraw early in most cases due to the 5 year rule.

Determining Distributions: What You Need to Know

How exactly can accountants determine the best plan for withdrawal? In most cases, taking payments over the lifespan of the new IRA owner is the best plan. The amount of these distributions is calculated using a simple formula. First, you will need the age of the beneficiary as of December 31st of the year in which they received the IRA. You then determine their expected lifespan using IRS publications. The distribution is split so that the inheritor will get a balanced amount every year over their expected lifespan. This formula will need to be recalculated every year for the remainder of the beneficiary’s lifetime.

What happens if you do not withdraw the full amount or set up distributions within five years? Th penalties can be very steep, usually a fine of 50% of the money that was left in the account. This is an unfortunately easy way to squander one’s inheritance. Good planning and expert financial advice can easily help to avoid this loss.

Planning Ahead With an Inherited IRA

Because tragedies happen, there is a decent chance that the new IRA beneficiary will leave the account to a new person. This requires special planning. Even if a person leaves all of their assets to a particular person or persons in their will, the retirement account will only go to the person listed specifically as a beneficiary in the account paperwork. Clients should be advised to name the beneficiary specifically when filing paperwork to claim their own inheritance.

An inheritance can be an immense gift, including an inherited IRA. Many in Generation X and the Millennial generation will be given an advantage in their lives through the inheritance of retirement accounts from parents and grandparents. These people in turn will need expert advice to reap the maximum benefit from these accounts. Every accountant needs to know how to guide their clients through the minute details of inheriting different kinds of wealth.

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