Common Pitfalls with Inherited IRA Accounts

You are probably familiar with the tax rules for traditional IRAs and Roth IRAs, but many people are un-aware of the different set of rules for an inherited IRA. The purpose of this post is to point out a few of the tax rules as well as some of the common pitfalls to watch out for.

Tax Rules for Inherited IRAs

• Whether you inherit the IRA as a spouse or someone other than a spouse will affect the applicable rules. A spouse who inherits an IRA can co-mingle funds with their own IRA; and then the normal IRA required minimum distribution rules apply. On the other hand, if - as the surviving spouse - you plan on withdrawing before age 59 ½ to supplement your income, the better option may be to leave the Inherited IRA in a separate account for withdrawals. This way you can avoid the early 10% penalty when making withdrawals.
• If your inherited IRA is not from a spouse, you must keep the inherited IRA money separate from any other IRA and you can’t make new contributions to the inherited IRA account.
• There is no 60-day rollover rule for an inherited IRA. Any transfers involving an inherited IRA must be between trustees only; you can not have the custodian send you checks unless it is a distribution.
• You must take Required Minimum Distributions (RMD) whether you inherited a traditional IRA or a Roth IRA. How you take them depends on whether the account owner died before, on, or after his or her required beginning date (RBD):
  • If the account owner died before the RBD, your choices are:
    • Take distributions over your lifetime according to the IRS life expectancy table, or
    • Choose to receive the entire account by the end of the fifth year following the year of the owner’s death. If the account owner died on or after the RBD, you must use the life expectancy method.

Common Pitfalls

• Forgetting to take the final RMD in the year of death - if the original account owner did not withdraw the entire RMD before death, beneficiaries must withdraw any remaining RMD from the account by the end of the year of death.
• Mistitling the Inherited IRA - When you inherit an IRA, you need to make sure your custodian titles the new inherited account correctly to avoid possibly disqualifying the account. Commonly seen titles may read like this: “John Smith, Deceased IRA FBO (For the Benefit of) James Smith, Beneficiary” or “Jim Smith, IRA BDA (Beneficiary Designation Account), Original Depositor John Smith)”.
• Naming a special needs child as a beneficiary - if a special needs child inherits an IRA outright; the IRA assets may compromise the child’s access to public benefits such as Supplemental Security Income, Medicaid, or Affordable Housing. You can use a Special Needs Trust to eliminate this problem; please seek advices from a qualified estate planner.
• Failing to comply with the Separate accounts rules - if there are multiple beneficiaries on the account, you must have the IRA account divided into separate accounts before December 31st following the year of original owner’s death. Failing to do so may cause accelerated distribution.