An inherited IRA can provide a lifetime of tax-deferred or tax-free investment growth. But as you try to build your nest egg, strict IRS rules make inherited IRAs as fragile as eggshells. Mishandle them, and they will crack, with all of their tax benefits spilling out and going to waste.

Example: A man inherited a $600,000 IRA from his father. Had he left the money in that IRA, the continued tax-deferred investment growth might have provided him with millions of dollars of income over his lifetime. Instead, he transferred the money to his own IRA account, instantly ending the tax-deferred growth and making all of those tax-deferred assets count as taxable income in a single year, pushing him into a very high tax bracket. Only $360,000 remained after the IRS took its share.

Here’s how to avoid costly missteps if you inherit an IRA…

TRANSFERRING AN IRA

If you are designated as the beneficiary of an IRA from your spouse, you can simply roll the money over into your own IRA without penalty. But if the IRA belonged to anyone other than your spouse, the IRS has very specific rules that you must follow—and very steep penalties for breaking those rules.

Here’s what to do…

First, make sure that you have formal proof you are the beneficiary. You may already know or suspect that you have been designated as the beneficiary. And if you locate a copy of the signed beneficiary form in the files of the deceased, there should be no problem. If not, the IRA custodian—the institution that manages the IRA, such as a bank or mutual fund company—may have a copy. But such paperwork sometimes gets lost, particularly when financial institutions merge.

If no copy can be found, the IRA likely will become part of the deceased person’s estate, which could greatly inhibit your ability to stretch out required minimum distributions (RMDs) from the account.

IRS rules do not allow heirs to stretch out these withdrawals from IRAs based on their own projected life spans if the IRA has passed through the estate. When this occurs, heirs instead generally must withdraw all assets by the end of the fifth year following the year of the IRA owner’s death.

Exception: If it is a traditional IRA rather than a Roth IRA and the original owner was at least 70½ when he/she died, the five-year rule does not apply. Instead, the heir must make withdrawals based on the deceased’s required withdrawal rate.

Contact the IRA custodian and retitle the IRA—but do not retitle it under your own name. To retain its tax-advantaged status, an inherited IRA must be retitled in a specific format—“John Smith IRA, deceased (insert the date of death), F/B/O (for benefit of) John Smith, Jr., Beneficiary.” The precise wording varies slightly from custodian to custodian.

When an inherited IRA is simply retitled under the beneficiary’s name, the IRS considers it no longer valid. Not only does the heir lose the right to stretch out withdrawals over the remainder of his projected life, but all of the money in the IRA is treated as income in the year that the retitling occurred, potentially pushing the heir into a very high tax bracket.

Rolling the inherited IRA into your own existing IRA would produce similar results—plus it’s likely to trigger a 6% penalty for making excess IRA contributions.

Warning: IRA custodians sometimes delegate IRA retitlings to poorly trained low-level clerks who might not understand the nuances of titling and handling inherited IRAs. Every time you speak with an IRA custodian, ask the following—“Do you understand that this is an inherited IRA? Are you familiar with how an inherited IRA must be handled?”

If you have any doubts about the custodian’s competence, review the forms carefully before you sign off and/or ask your financial adviser or accountant to contact the custodian on your behalf and confirm that the IRA is being handled properly.

In some cases, it might be possible to correct a mistitled IRA, particularly if the problem is spotted quickly—but not if the assets have become comingled with the heir’s noninherited IRA.

Take any required minimum distribution. Once the owner of a traditional IRA reaches age 70½, the IRS requires that he take annual withdrawals. (This does not apply to Roth IRAs.)

If you inherit a traditional IRA from someone older than this, check with the custodian to see whether sufficient withdrawals already were taken during the year of the person’s death. If not, it’s up to you to do so by year-end.

Failure to make this withdrawal will result in a steep 50% penalty on the amount that should have been withdrawn. Use IRS Publication 590, Individual Retirement Arrangements, to determine the size of the required withdrawal, or ask the IRA custodian or a tax professional for help.

This is a different table from the one you use to calculate required withdrawals from your own IRA—a potential source of confusion.

Consider disclaiming the inherited IRA if it makes sense to allow the assets to pass to “contingent” beneficiaries—that is, beneficiaries who inherit if the primary beneficiary does not. This could be prudent if you do not need the money…if you are in a profession where lawsuits are common…or (in some states) if you wish to protect the money from your creditors.

If there are multiple beneficiaries, divide up the IRA by the end of the year following the year of the IRA owner’s death, if not sooner. Fail to do so, and the IRS will insist that each heir calculate all future required withdrawals based on the age of the oldest beneficiary, reducing the ability of younger beneficiaries to stretch out their withdrawals.

MAINTAINING THE IRA

Even after the inherited IRA is set up, it still is different from your personal IRA in some important ways. What to do…

Request a direct trustee-to-trustee transfer if you wish to shift the inherited IRA to a different custodian. If the money is ever in your hands, the IRS will consider it permanently withdrawn from the IRA.

Some heirs believe that as long as they redeposit inherited IRA money with a different IRA custodian within 60 days, they can take possession of it without damaging its tax-deferred status or incurring taxes. That’s incorrect—this 60-day window exists for our own IRAs but not for inherited IRAs.

Never make contributions to an inherited IRA or roll your own IRA assets into it. The IRS will consider the inherited IRA no longer valid if you do this, ending its tax-deferred growth and potentially triggering a big tax bill.

Make annual withdrawals from the inherited IRA starting in the year after the year of the IRA owner’s death. Heirs sometimes assume that they do not need to make withdrawals until they themselves turn 70½…that they don’t need to make minimum withdrawals from an inherited Roth IRA…or that withdrawing money prior to age 59½ will result in early withdrawal penalties. These rules apply to your own IRAs but not to inherited IRAs.

With the exception of spouses who roll inherited IRA assets into their own IRAs, those who inherit IRAs generally are required to make annual withdrawals regardless of their age and regardless of the age at death of the IRA’s original owner. (But those required to make all withdrawals by the end of the fifth year following the death can make withdrawals however they like during that span and need not remove money every year.)

This applies to Roth IRAs as well as traditional IRAs. There are no early withdrawal penalties for inherited IRAs.

If you have failed to take required withdrawals from an inherited IRA in years past, file IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, for each year that you should have done so. Request a waiver of the 50% penalty for each year—if it was an honest mistake, the IRS might be lenient.

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