The MOST Important Piece of Information IRA Beneficiaries Must Know

By Sarah Brenner, IRA Technical Expert
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Are you named as a beneficiary on an IRA? It probably is not your intention to have a large portion of that inherited IRA go to taxes. How can you avoid this unfortunate outcome and maximize your IRA tax advantages? What is the most important thing you need to know as an IRA beneficiary?

When you inherit an IRA, don’t immediately take a distribution! By doing so, you may lose an important tax break, the ability to stretch required minimum distributions (RMDs) from the inherited IRA over your life expectancy and even have the RMDs continue to a successor beneficiary after your death. While there has been legislation proposed to eliminate the “stretch” tax break for IRA beneficiaries, currently it still remains available and beneficiaries will want to know how to take advantage of it. Consider the following two examples where similarly situated beneficiaries end up with very different results when one uses the stretch option and the other does not.

Greta, age 50, was the beneficiary of her mother’s IRA. At the time of her mother’s death, her IRA was valued at $500,000 and contained only pre-tax funds. After her mother’s death, Greta contacted the IRA custodian and requested that the funds in IRA be paid to her. The IRA custodian distributed the funds to Greta. Greta must now include $500,000 in her taxable income for the year.

Michael, age 50, was the beneficiary of his father’s IRA. At the time of his father’s death, the IRA was valued at $500,000 and contained only pre-tax funds. When his father died, Michael did not immediately take a distribution. He met with a financial advisor who told him that he did not have to take all of the funds out of the IRA immediately. He could stretch RMDs from the inherited IRA over his life expectancy. He could also name a successor beneficiary, who could continue to take RMDs from the inherited IRA over Michael’s life expectancy after his death. The stretch allows Michael to maintain the IRA and continue to have the benefit of tax-deferred earnings. The tax consequences of the distributions would be minimized as the RMDs would be spread over a number of years.

Are there any remedies when a distribution is taken from an inherited IRA and the beneficiary has second thoughts after discovering the negative tax consequences? A spouse beneficiary may roll over an unwanted distribution from an inherited IRA into their own IRA within 60 days. When this happens, the IRA is no longer an inherited IRA. A non-spouse beneficiary may not roll over a distribution from an inherited IRA. The funds are no longer IRA funds and the rules provide no way to reverse the transaction. Greta, from our first example, does not have the option to roll over the funds within 60 days. This is why the most important thing a beneficiary must know is to not immediately take a distribution from an inherited IRA. There is no remedy for this mistake!

Beneficiaries should be educated about their choices before they make them. If you are an IRA beneficiary, taking the time to consult with a knowledgeable financial advisor instead of immediately taking a distribution from the IRA you have inherited is a wise move. Exercising the stretch option as a beneficiary is not a complicated process but it must be done correctly and there are no do-overs. Taking a lump sum distribution from your inherited IRA ends your ability to use the stretch option.