The IRA Beneficiary 2 Step

Are you going to leave a retirement account to your heirs?

On average, a person who dies with their retirement account mostly intact leaves about $177,000 to his or her heirs.[1] And while that’s probably not enough to chuck it all and move to the Bahamas, who doesn’t appreciate a good windfall?

The problem with sudden windfalls, as history has repeatedly shown us with lottery winners, is that inherited money is extremely likely to be spent rather than saved.

Of course, as an advisor for 25 years, I’m all for saving. But while spending inherited money instead of putting it away for a rainy day is a shame, at least when your heirs inherit cash and go on a shopping spree they’re actually getting something in return.

Lots of beneficiaries of retirement accounts can’t even say that.

That’s because not all inheritances are created equal. Do you have a retirement account that is largely (or entirely) intact that you plan to leave to your spouse or children? Did you know that there are numerous legal reasons why a shockingly large percentage of certain types of inheritances may never see the inside of their pockets? That’s because far too many people make hasty transfer and tax related errors that can take a big bite out of their new-found wealth.

You need to be educated about these accounts so that you can leave a legacy that makes an impact.

The Many Fathers of Retirement Accounts (IRA)

You may think that transferred wealth is bound by precise tax codes and beholden to concrete transfer laws, making it a decision-and-risk-free process, but that’s not the case. In fact, of all the sources of money you’re likely to leave to your heirs, one of the most easily-mismanaged involves money from an Individual Retirement Account (IRA).

Unlike, say, cash left to an heir from a savings account, when you pass along an IRA, your heirs are thrust into a complex maze of tax regulations and minimum withdrawal dates that may require them to deal with 3 unique forces, including:

  • Tax Planning
  • Estate Planning
  • Financial Planning

The problem is that each of these entities may have some influence over the process, meaning one ill-informed step (or mistake of omission) and your heirs could be needlessly forced to pay thousands of dollars.

Let me repeat that: Common (and perhaps even understandable) errors made in the transfer process of retirement accounts happen all the time, and they needlessly waste many thousands of dollars.

What should your heirs do when they inherit an IRA?

Right up front, let me say that the rules governing the transfer of money from an inherited IRA are complex and subject to change. That’s why it’s important to speak with an expert before you do anything.

I once met a person who had inherited a large IRA. Great, right? Not in this instance. They immediately transferred the money from the inherited IRA to a basic savings account, and then excitedly called our firm and said: “What do I do now?”

Big mistake. They had to pay taxes on the entire IRA as if it were earned income.

What follows are two common scenarios for inherited IRAs. Please remember that this is merely an introduction, and that you should speak with your advisor before making any moves regarding your IRA.

1) Your spouse dies and leaves you their IRA.

This is usually the most straightforward case. If you inherit a traditional IRA from your spouse, you can roll that money into your own IRA, which means you won’t have to take required minimum distributions until you turn 70½. But if you need the money right away, and you are under the age of 59½, you can take withdrawals, but you are hit with a 10 percent early withdrawal penalty. In certain circumstances, you can actually avoid that penalty by retitling the account as an “inherited IRA,” only to then turn around and retitle it again (in your own name) when you reach age 59½. (This “retitling again” means you won’t have to take any more distributions until you reach age 70½, so the money will continue to grow tax-deferred.)

2) You pass away and leave a child your IRA.

Children, unlike spouses, cannot roll IRAs into their own names.That’s because if they decide to liquidate the account, they not only get nailed for income taxes, they lose out on the tax shelter that is a traditional IRA.

Typically, children who inherit an IRA should retitle it as an “inherited IRA.” After that, they’ll be required (based on their age) to take at least a minimum distribution (but they can take more), which they’ll be taxed on, but the money they leave in the account will continue to enjoy tax-deferred growth.

Conclusion

The above two scenarios are merely an introduction. If it seems like the rules and regulations regarding inherited IRAs are frustratingly complex, it’s because they are. Remember, if you are leaving an IRA (or any retirement account) to someone, or if you simply feel you need to gain clarity about the process, speak with your advisor to receive the most up-to-date information regarding the laws that pertain to the transfers of these types of accounts.

[1] CNN Money December 13th, 2013