When you inherit an IRA, tax treatment and required minimum distributions (RMDs) can be tricky.
For non-spouse beneficiaries, RMD options depend on the type of IRA and the age of the account holder at the time of death.
Make sure you understand the rules and consider talking to an advisor before taking a distribution.
My mom just passed away at 66 years old and left me her IRA. I'm 41. When do I need to start taking the RMD? —A Reader
First, my sympathies. Losing a parent is never easy, and having to deal with financial issues at the same time doesn’t help. And I wish I could tell you that the rules governing inherited IRAs are simple but, unfortunately, they're not. When you inherit an IRA, tax treatment and required minimum distributions (RMDs) depend on the type of IRA, the number of beneficiaries, and whether a beneficiary is a spouse or non-spouse. The IRA account owner’s age at the time of death is also a factor.
For the record, the simplest situation is when the beneficiary is a spouse. In that case, the spouse can just treat the IRA as their own. However, for a non-spouse beneficiary such as yourself, it’s a bit more complicated. Taking an RMD is one option as you suggest, but there are a couple of other things to think about before taking action. Hopefully the following will help you understand your choices.
You can take the money as a lump sum
For the benefit of other readers, an RMD is the amount that the IRS requires anyone age 70½ or older to withdraw every year from tax-deferred retirement accounts. As a beneficiary, you are also bound by RMD regulations.
There is, however, another option to take the assets as a lump sum. The upside is that you have access to all the money right away, and there's no 10 percent penalty for early withdrawal. The downside is that you'll pay ordinary income taxes on the distribution, which could be quite a sum depending on the amount of the inheritance.
Plus, the distribution itself could bump you into a higher tax bracket. Unless you need the money right away, taking a lump sum may not be the most tax-efficient choice, but I think it's important to consider all your options.
You have two choices for taking an RMD
Because your mother was under age 70½ when she passed away (the year in which she would have needed to start taking her own RMD), there are two ways that you can take an RMD:
1) The Life Expectancy method allows you to take an annual RMD spread over your own single-life expectancy. This is based on IRS life-expectancy tables and determined by your age in the calendar year following the year of the IRA holder’s death. You must start taking distributions no later than 12/31 of the year after the date of death. The distribution will be re-calculated each year. Here’s how it would work in your situation:
You were 41 when your mom passed away. You won’t have to begin taking an RMD until the year after her death, when you’ll be 42. At that time, according to the IRS Single Life Table (Table I in Appendix B of IRS Pub 590-B ), your remaining life expectancy is 41.7 years. Therefore, your RMD that first year will be the IRA balance as of 12/31 the year your mother died divided by 41.7. The following years you simply subtract one year to get your life expectancy and divide the remaining balance by that number.
Yes, it seems complicated but, fortunately, your financial institution may help you with the calculations. And of course, you can always choose to take more than the RMD.
2) The Five-Year method is a bit simpler. It allows you to take distributions of any amount at any time up until 12/31 of the fifth year after the year the account holder died. At that time, all assets must be fully distributed. (This method is not available if the deceased was 70½ or older.)
While there’s no 10 percent penalty with either method, you will have to pay ordinary income taxes on each distribution the year you take it. Again, you’ll want to consider how this added income may affect your tax bracket.
A word about Roth IRAs
Even though a Roth IRA owner doesn’t have to take an RMD, the beneficiary does (unless assets are distributed in a lump sum). For an inherited Roth, the RMD is calculated as though the account owner had died before age 70½ (per above) regardless of the actual age at death, so you still have the choice of methods.
The good news is that distributions from an inherited Roth are income tax-free provided the owner had held the account for at least five years. If the account is less than five-years-old, distributions of earnings may be taxable.
Two important caveats
First, as a non-spouse beneficiary, it’s extremely important how you title the account. Do NOT put it in your name. If you do, the entire account will be treated as a distribution—and you’ll have to pay any applicable taxes on the total. Instead, title the account as: “(owner’s name), deceased (date of death), IRA FBO (your name), Beneficiary.”
Second, whatever method you choose, you absolutely must take the RMD by 12/31 of each year. If you miss that date, the penalty is a whopping 50 PERCENT of the amount you should have taken!
On the positive side
There’s a lot to think about and the rules are complex, but taking an RMD does have its benefits. For one, the undistributed assets keep growing tax-free—which can be significant over time. Plus, you can manage the assets according to your own goals and time horizon. At this point, I’d suggest talking to a financial advisor who can help you look at your choices in light of your overall financial situation. Think of it as an opportunity to manage your inheritance to your best advantage and, in so doing, honor your mother’s legacy.
Have a personal finance question? Email us at firstname.lastname@example.org . Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.