You've worked hard to fund your golden years with an Individual Retirement Account (IRA). But what happens to that money when you die?
Well, since you won't be around, maybe you're not worried about it. But financial commentator Greg Heberlein says a little planning now can make things easier on your loved ones down the road.
The inheritance rules for IRA, 401(k) and 403(b) funds are generally the same. For simplicity's sake, we'll refer to them all as IRAs.
The first thing to keep in mind is that Washington is one of nine community property states. That means a spouse will receive the deceased’s share of the property with no tax consequences. But that doesn't mean you don't have to worry about how you handle IRA money.
It is easy to confuse IRA inheritances as being subject to step-up provisions.
If you own a stock that's not in an IRA, IRS rules allow you to will it to your heirs at its price at your death, not the price when you bought it. That means when an heir sells the stock, the gain is calculated only from the price at the time the individual died.
But that’s not true if the investments are held in an IRA.
The rules can be complicated. When you encounter such a situation, immediately check to see what the most current rules are. You can do that with IRS Publication 590.
When you inherit a traditional IRA, there is no step-up in value. That’s because no taxes were paid by the previous owner.
If you don’t withdraw any assets from the inherited IRA, you are not taxed immediately.
If it is a Roth IRA, you will never be taxed. However, the Roth IRA must have existed for at least five years before you can make a withdrawal.
If you're inheriting a traditional IRA, you can cash it in immediately. But you’ll have to pay income tax on that amount.
If it is your spouse who died, you may combine that IRA with your own and avoid mandatory withdrawals until you are 70-and-a-half.
If the IRA is inherited and you haven’t reached age 59½, there is no 10-percent penalty on withdrawals, as would normally occur with your own IRA. But if you're a surviving spouse and rolled it into your own IRA, then the early withdrawal penalty will apply if you are not 59½.
If the deceased is not your spouse and has not taken any IRA withdrawals, there are several ways you may take withdrawals. For many, the preferred option is the 5-year rule. You skip withdrawals and cash out the IRA within 5 years.
If you do decide to make withdrawals right away, the principal formula for determining the minimum withdrawal amount is based on your age, not the deceased’s. That usually means your withdrawals will be smaller than for the person who died. That way, you can spread out the income tax over a longer period.
Handling an inherited IRA is complicated. Do the wrong thing and your immediate tax bill may skyrocket!
We've only touched on the basic rules here. This is the kind of situation where seeking professional help, and/or consulting with the IRS, is strongly recommended.