Rules for Rolling Over Inherited IRA Assets

What do you do when you inherit an IRA? Inheritance is not an everyday event and most people haven't the first clue about investing their inherited retirement assets. If you take a personal check, for example, it's already too late. The rules say you have to take distributions in a specific way or else the entire inheritance could become fully and immediately taxable. Understanding the rules will go a long way to making sure that you, and not the Internal Revenue Service, will benefit most from your windfall.

Rollover an Inherited IRA – Nonspouses

Many people think that you can roll an inherited IRA fund into your own IRA, but this is not the case for nonspouses. When your friend or relative dies leaving his IRA to you, the very first thing you must do is transfer the account's assets into a new IRA held in your name. This account is called an "inherited IRA" or a "beneficiary IRA."

It's important to get the titling of this account right otherwise the account might get confused with your personal IRA and result in a whopping tax bill. The deceased's name must appear in the account alongside your own name as beneficiary, and it should also be clear that the account is an inherited IRA. For example, you might name your account "Uncle John Doe (Deceased 6/12/2018), IRA, FBO Lucky Louise Little, Beneficiary." FBO means "for the benefit of."

Inherited IRA Rollover Rules

Once the inherited IRA is set up, the account custodian will arrange for the inherited assets to be transferred from the original owner's IRA directly to your inherited IRA. There are no taxes or penalties associated with a direct rollover performed in this manner.

It is strictly forbidden to do a 60-day "indirect" rollover for nonspouses. An indirect rollover occurs when the money is handed to you personally, and you become responsible for transferring the money from the old account to the new one within a 60-day window. If you miss the deadline, then taxes are immediately due on the distribution along with an early withdrawal penalty of 10 percent if you are younger than 59 1/2.

A nonspouse beneficiary cannot do this type of rollover under any circumstances. If you did make the mistake of withdrawing the funds from the deceased's account, they would immediately become taxable. You would not be permitted to roll the distribution into an inherited IRA, and you would not be permitted to put the money back into the old IRA. Once the money's out, it's out, and with potentially disastrous tax consequences.

Surviving Spouse Inherited IRA

Surviving spouses have more flexibility in how to handle inherited IRA assets:

Option one: Transfer the assets to an inherited IRA

Surviving spouses may roll the money into an inherited IRA with themselves named as beneficiary, just as a nonspouse beneficiary would do.

Option two: Designate yourself as sole owner of the deceased's account

If you designate yourself as owner of the deceased's account, the money will be treated as if it had always been yours. If you are below the age of 591/2, a 10 percent early withdrawal penalty will be levied if you withdraw money from what is now your IRA. At age 70 1/2, the calculation for required minimum distribution will be based upon your life expectancy, not the deceased's.

There's one small caveat to this rule: if the deceased was already taking RMDs at the time of his death, you'll have to take whatever distribution the deceased was required to take in the year of death. The following year, you should switch to calculations based on your own life expectancy.

Option three: Rollover to a personal IRA

Unlike nonspouse beneficiaries, surviving spouses have the option of rolling the deceased's IRA into their own IRA or a qualified employer plan such as a 401(k) or 403(b). Usual rollover rules apply. If you receive a personal check for the account balance, you have 60 days from receiving the check to roll the money over into your own IRA.

Inherited IRA Features

An inherited IRA is a special type of IRA that you must open when you inherit an IRA after the original owner dies. They have unique characteristics and follow some, but not all, of the rules for traditional or Roth IRAs. Here's a breakdown:

• You can open an inherited IRA in any form, including traditional, Roth and rollover. The only rule is the inherited IRA must be in the beneficiary's name as the beneficiary, meaning the money must be kept separate from his personal IRA accounts.
  
• You cannot make contributions to an inherited IRA or roll money into or out of the account. It exists solely to hold your inheritance.
  
• Investments held within an inherited IRA will grow tax-free just like any other type of IRA.
  
• Withdrawals from an inherited traditional IRA are taxed at general income tax rates. Because Roths are funded with post-tax dollars, you don't pay tax on qualified withdrawals from an inherited Roth IRA.
  
• Withdrawals are not subject to the 10 percent early withdrawal penalty for beneficiaries.
  

This last point is critical. With your own IRA, you'll be heavily penalized if you take money out before you reach age 59 1/2, to the tune of 10 percent of the withdrawal. The penalty does not apply to an inherited IRA and you can, and sometimes must, start taking money out penalty-free straight away.

If you contribute to the inherited IRA, then you void its "inherited" status. The entire account balance becomes immediately taxable and you may get pushed into the highest tax brackets for federal and state taxes. Take care which account you're making contributions to – getting it wrong could be an expensive mistake!

Inherited IRA Distribution

When you're ready to start making withdrawals from your inheritance, you basically have two options:

Option one: The five year rule

If the deceased was aged under 70 1/2 at the date of death and was not yet taking RMDs, you can cash out the entire account within five years. You will pay federal and state income taxes on the amount of the withdrawal, but no 10 percent premature withdrawal penalty. The last date for liquidating the entire balance is Dec. 31 of the fifth year following the decreased owner's death – i.e., 2023 for a person who dies in 2018. This is known as the "five year rule." You can take distributions at any time up to this date.

Option two: Stretch IRA

A second option is to withdraw the money from your inherited IRA slowly over time via a so-called "stretch IRA." The rule is that you must take RMDs from the inherited IRA each year. The amount is calculated according to an IRS formula based on the account balance and your life expectancy. IRS Publication 590 has a worksheet to help you figure out your RMDs, and there are plenty of online calculators that will do the math for you.

Note that an inherited IRA RMD is a minimum distribution – you can always withdraw more if you like.

With a stretch IRA, you must take the first RMD by Dec. 31 of the year following the calendar year of the original IRA owner's death. If he died in May 2018, for example, you must start taking withdrawals by Dec. 31, 2019. The nice thing here is that you pay taxes in a drip fashion only on the amount withdrawn. The rest of the inheritance will continue to grow tax-deferred in the inherited IRA.