Planning can help avoid tax penalties and ensure growth for inherited IRAs

Trouble-free transfers

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Inheriting an IRA from a deceased spouse or parent involves a lot more than simply transferring the assets to a new bank account. If certain rules established by the IRS are not followed, the inheritance will be taxed immediately on the entire amount.

The greatest gift that an individual retirement account brings is that the interest, dividends and capital gains are allowed to grow tax-deferred, so experts say it is better to leave as much money as possible in the account. But in order for an IRA to keep its tax advantages, in most cases it must be renamed or retitled to reflect that it was inherited from someone else.

"If you put the money just in your name and you don't mention the person you inherited it from, it gets taxed," said Jane Bryant Quinn, a personal finance columnist for AARP Bulletin and author of the book "Making the Most of Your Money."

"Many financial advisers don't know this," Ms. Quinn said. "I get a ton of mail from people who failed to retitle an IRA and they want to know if it can be undone. The answer is no. Once it's done, it's done."

Tax issues related to inherited IRAs are becoming more common now that more baby boomers are beginning to receive accounts passed down from deceased spouses and parents.

Even if a deceased person had accumulated retirement funds through a company 401(k), when workers retire from their jobs they often roll that money into an IRA. The same rules on retitling IRAs, however, also apply to inherited company 401(k)s.

"There's also research showing most people with IRAs don't withdraw the money right away," Ms. Quinn said. "They wait until age 701/2 when they have to, which makes it more likely there will be money for children or other heirs to inherit."

Surviving spouses who inherit traditional IRAs do not need to retitle the accounts, and the money can be left alone until the age of 70 1/2 when required withdrawals begin. Younger spouses who may need the money before age 591/2 will face a 10 percent penalty for early withdrawal. Spouses can avoid the 10 percent penalty by retitling the account as an "inherited IRA."

Ms. Quinn said a surviving spouse who retitles an IRA as an "inherited account" should retitle it again to his or her name alone at age 591/2 in order to defer any further withdrawals until age 70 1/2.

A child or non-spouse inheriting an individual retirement account is required to retitle the account as an "inherited IRA" in order to avoid being immediately taxed on the whole amount. Every year, based on age, the non-spouse is required to make a minimum withdrawal. If a non-spouse dies before withdrawing all the money, the new heir must again retitle the account as an "inherited IRA" and complete the withdrawals on the same schedule.

Raymond Parker, an attorney at the Williams Coulson law firm, Downtown, offered a detailed illustration of how retitling an inherited IRA allows the account to keep growing in value tax deferred after the original owner's death:

Assume Sean inherits an IRA upon the death of his father, Joe, in 2012, he said. An inherited IRA account should be established for Sean titled as follows: "IRA of Joe, deceased, for the benefit of Sean," reporting under Sean's Social Security number.

Mr. Parker's example also assumes Sean will turn 53 in the year 2013 when required distributions based on his life expectancy commence. The IRA Single Life Expectancy Table indicates that at age 53, Sean has a 31.4 year life expectancy. In 2013, Mr. Parker said Sean's required minimum distribution amount will be computed as follows:

The balance of his inherited account on Jan. 1, 2013, times the fraction 1/31.4. For years after 2013, Sean reduces his life expectancy by one year from what it was in 2013. So, in 2014, his required distributed fraction is 1/30.4, and in 2015 it is 1/29.4, and so on.

"This minimum required distribution fraction applies to this inherited IRA even if Sean dies," Mr. Parker said. "The IRS really doesn't care who the account passes to at that point, since it has no affect on the required minimum distribution rate from the inherited IRA, which was set for Sean's inherited IRA in 2013."

The main things people need to know about inherited IRAs, Ms. Quinn said, is the accounts need to be retitled and that heirs do not need to withdraw all the money right away.

"You can stretch it out over your lifetime, and all during those years the money can compound tremendously and you'll have much more money if you do that," she said.

"It's important for people who have IRAs they plan to leave to their children to understand this angle so they can tell their kids about it. I recommend they leave something with their will explaining inherited IRAs to children so their children won't make a mistake."

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Tim Grant: or 412-263-1591. First Published November 8, 2012 5:30 AM


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