Death is never closer to mind than the end of October. From Halloween to Day of the Dead, the end of October and start of November are a time for remembering our ancestors. For the heirs of the recently departed, this may mean determining what to do with an inherited IRA.
“Understanding the ins and outs of an inheritance can be overwhelming, especially during a difficult time,” says Mike Loewengart, vice president of investment strategy at E-Trade Capital Management.
Sometimes it helps to tie an emotionally-fraught situation to a joyful one. Unlike Halloween, Day of the Dead is a joyful, life-affirming celebration. Here are a few important lessons Day of the Dead can teach us about inheriting an IRA.
Relationship matters. Day of the Dead honors those who have passed away, friends and family alike. With an inherited IRA, your relationship to the deceased matters, Loewengart says. “If you’re the spouse, you have flexibility in what you can do with the funds.”
Spousal beneficiaries — including all couple types lawfully married in one of the 50 states, the District of Columbia, a U.S. territory or a foreign jurisdiction — can take ownership of inherited IRA assets and treat them as their own.
Non-spousal beneficiaries don’t have this option. They must keep inherited IRA assets in a separate account where they can’t make contributions and must take required minimum distributions (RMDs) each year based on the inherited IRA owner’s life expectancy. Both pre-tax and inherited Roth IRAs have RMDs.
The upside is you can withdraw as much as you want from an inherited IRA in any given year without penalty, but you will pay ordinary income taxes on withdrawals from pre-tax inherited IRAs.
You have until Dec. 31 of the year following the original owner’s death to begin taking RMDs, with one exception: If the original owner was 70½ or older and did not take his RMD the year he died, an RMD must be taken out by Dec. 31 of the year of death as well.
[See: 10 Tips for Couples and Young Families to Build Wealth.]
A penalty-free loophole for spouses. Inherited IRA rules can play to a spouse’s favor, says Michael Landsberg, an Atlanta-based member of the American Institute of CPAs Personal Financial Specialist Credential Committee. Say you inherit an IRA from your spouse when you’re 55. According to IRS rules, you can’t access your own IRA assets until you turn 59½ without incurring a 10 percent penalty.
But if your spouse bequeaths you an IRA, you can put it in an inherited IRA instead of combining it with your own. This way, you’ll be able to access the money in the inherited IRA without penalty.
If at any time you decide you no longer need the funds from the inherited IRA, you can roll it into your own IRA to pause the RMDs until you reach 70½, Landsberg says.
Mark your calendar. As you mark Day of the Dead on your calendar, there are two important dates to make note of after inheriting an IRA: Dec. 31, when RMDs must be taken by, and Sept. 30 of the year after death.
According to IRS rules, joint beneficiaries have until Sept. 30 of the year after death to separate inherited IRA assets. So if you and your brother are co-beneficiaries on your mother’s IRA and she passes away in 2018, you have until Sept. 30, 2019, to split the assets into inherited IRAs in each of your names.
If you don’t split the inherited IRA by then, the RMDs default to the life expectancy of the oldest beneficiary, Landsberg says.
Splitting the IRA is even more important if your joint beneficiary is a non-human entity, such as a trust or charity. Since non-human entities are not considered designated beneficiaries and have no life expectancy, the inheritance defaults to the five-year rule, Landsberg says.
The five-year rule states that beneficiaries must withdraw all assets from an inherited IRA by Dec. 31 of the fifth year after the original owner’s death. This accelerated withdrawal rate will “crush the after-tax amount you get,” Landsberg says, so “do whatever you can to avoid it.”
Give yourself time. Your inheritance, like remembrance, is best taken in doses. Whenever you take a lump sum out of an IRA, you incur a large tax bill and lose the benefit of tax-deferred growth, says Lori Rodgers, a senior wealth strategist at PNC Wealth Management in Pittsburgh. There are no taxes with inherited Roth IRAs, but you do lose the tax-free growth.
If you don’t need the funds, buy yourself and your inheritance some time by leaving as much of the money in the inherited IRA wrapper as you can, she says. Or, in the case of spouses, roll it over into your own IRA to forstall RMDs.
[See: Build Your Investment Strategy With These 9 Questions.]
Clean house. Day of the Dead celebrations involve cleaning the deceased’s gravesites. It’s like a giant graveyard picnic with weed-pulling. Songs are sung and feasts are eaten as ancestor’s gravesites are given some TLC. You needn’t sing a song over your inherited IRA — although you certainly could — but you should take a weed puller to the investments within it.
Sometimes there’s a sentimental attachment to inherited assets, says Michelle Brownstein, senior vice president of private client services at Personal Capital in San Francisco. You may feel compelled to hold onto your relative’s investments in honor of their memory. But there are better ways to cherish a loved one’s memory, especially if those investments are not a good fit for your financial goals.
“It’s really analogous to inheriting old clothes,” says Nora Yousif, a vice president financial advisor at RBC in Boston. “They may not fit you quite right so it’s important to reassess and see what really suits you.”
If you’re really struggling to let go of your loved one’s investments, consider keeping only a few of the shares, Brownstein says. This way you get the emotional benefit without throwing off your investment strategy.
Plan for the future. Day of the Dead is a celebration of the lives of the deceased, but it also serves as a reminder that death is an inevitable part of life. While death will hopefully be a distant part of your life, it’s best to be prepared.
Review your beneficiaries whenever you make a change, such as leaving a job or marriage.
Landsberg often sees new clients with their ex-spouse still listed as the beneficiary on their IRA. Since beneficiary designations on retirement accounts supercede any other estate planning documents such as wills or trusts, if your ex-spouse is listed as your beneficiary, that’s where the IRA will go.
[See: 10 Tips for Handling Investments and Divorce.]
You should also have contingent beneficiaries who the account will pass to if your primary beneficiary predeceases you. Otherwise, the IRA will go to your estate and default to the five-year rule.
Whomever you designate as your beneficiary, be transparent about it, Landsberg says. Let your heirs know what to expect. Death may come as a surprise, but inheritance shouldn’t.
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What Day of the Dead Can Teach Us About Inherited IRAs originally appeared on usnews.com
