If you recently inherited an individual retirement account (IRA) from someone other than your wife or husband, you will need to make certain decisions about where to deposit the funds and what taxes are involved. Unhappy adverse tax consequences may result if certain rules are not followed.
The rules that govern an inherited IRAs are different from rules that govern IRAs inherited by a surviving spouse. Upon the death of an IRA owner, ownership of the IRA passes to a beneficiary or beneficiaries that the owner designated in the terms of IRA. If a beneficiary is not the owner's surviving spouse, the IRA is treated as an inherited IRA.
Inherited IRAs cannot accept any rollover contributions that come from other existing IRAs, and any distributions from the inherited IRAs cannot deposited into other IRA's. However, you can deposit inherited IRA assets through a direct, trustee-to-trustee transfer, as long as the IRA into which amounts are being moved is established and maintained in the name of the deceased IRA owner "for the benefit of" you as the beneficiary.
If you go out and buy a new Aston Martin with your inherited IRA, then a somber faced IRS will demand payment of much of your inheritance for that year in which you received the funds. If you avoid temptation and keep the funds in the IRA account, you will not have to pay federal income tax on the assets in the inherited IRA until you begin receiving distributions from the account. However, inherited IRAs are subject to annual required minimum distribution rules. Generally you must receive required distributions over your life expectancy or within five years after the original IRA owner's death. The rules can be tricky, and generally depend in part on whether the original IRA owner died before the date on which he or she was required to begin taking distributions from the IRA. The original account holder generally must gradually start taking out funds after reaching age 70 ½.
If your Dad was the one who bequeathed the IRA, and he died on or after his required beginning date to make distributions, then the remaining assets in your Dad's IRA must be distributed at least as rapidly as under the method of distribution being used by your Dad as of the date of his death. Annual distributions are based on the beneficiary's life expectancy using the beneficiary's age in the year following the year of the IRA owner's death.
Taking distributions from your Dad's IRA over your life expectancy, as opposed to a lump sum distribution from the IRA, enables you to continue to grow your Dad's assets in the inherited IRA tax-deferred. You can always demand a lump sum payment; however, the amount requested may put you in a higher tax bracket for the year.
Contact us before you decide what to do with your Dad's pension funds. You'll be glad you did.