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Guiding Bewildered IRA Beneficiaries

Guiding Bewildered IRA Beneficiaries

Advisors can earn their fees and their clients' appreciation by boning up on what can be done with an inherited IRA.

When asked, “Why did you get into this business?” few advisors would say, “A passion for distribution options in inherited retirement accounts.”

But taking on the complexity of such accounts will certainly simplify your clients' financial lives, and that probably is why you did get into the business.

First, you need to know (or remember) what you're talking about. So here's a primer on all the different options available to those inheriting IRAs.

Easy = Expensive

Most inheritors of IRAs can, of course, cash out of the accounts as soon as possible, and do with the money what they please.

They will likely not owe any penalties on the withdrawals. But any money withdrawn will likely be considered ordinary income to the beneficiary, and taxed as such.

The cut that goes toward taxes will be especially onerous if the beneficiary is still working, and/or has taxable income from other sources (such as a pension, or Social Security).

IRA beneficiaries taking the money sooner instead of later can mitigate the tax damage by splitting withdrawals between two consecutive calendar/tax years, which might keep the inheritors in a lower marginal bracket overall.

But those who don't necessarily need the money now may be able to save a lot more in taxes by spreading the withdrawals out over a lot more years.

Spousal Inheritors

If the surviving spouse is the sole beneficiary, she can move the account tax-free into an IRA in her own name. Then the required minimum withdrawals (RMDs) will be calculated as if the IRA were always hers, and therefore upon her life expectancy.

However, penalties for early withdrawals from that IRA may also apply, just as if the IRA were always hers.

She can also open an inherited IRA, and transfer the assets from the deceased spouse's IRA into the new account. But the RMD rules for the new account will be a bit trickier.

If the deceased spouse died before turning 70 ½, the first RMD must be taken by Dec. 31 of the year after death, or Dec. 31 of the year the deceased would have turned 70 ½.

When the deceased spouse dies after reaching 70 ½, then the RMD from the inherited IRA is based on the surviving spouse's life expectancy, and must be started before Dec. 31 in the year after the late spouse's death.

Non-Spouse Beneficiaries

IRA beneficiaries who weren't married to the deceased IRA owner have fewer possible choices. If they don't need or want the money right away, there is a fairly standard protocol.

First, the IRA beneficiary opens an inherited IRA account, and transfers his portion of the IRA assets to the inherited IRA account.

Note that if there were multiple beneficiaries named for the original IRA, each inheritor can use his own life expectancy to determine the subsequent RMDs, as long as the inherited IRA is established and funded by Dec. 31 of the year after the IRA owner dies.

If the IRA isn't divided in time, all of the RMDs could be based on the life expectancy of the oldest beneficiary, which could cause both the distributions and the tax bill to be greater than what the other beneficiaries would probably prefer.

The timing for IRA RMDs for non-spousal beneficiaries is similar to that of spousal inheritors, with a twist.

If the owner passed away prior to reaching age 70 ½, non-spouse IRA beneficiaries have to take the first distribution by Dec. 31 of the year after the owner's death.

But the beneficiary can also delay distributions for as long as five years. However, at that point the inherited IRA has to be completely liquidated, and the amount will be taxable income.

When the original IRA owner dies after reaching 70 ½, the individual non-spouse beneficiary has to take the RMDs over his own life expectancy, and must take the first one by Dec. 31 of the year after the owner dies.

Tax Trimming Tips

Although IRA beneficiaries have a relatively narrow range of choices as to how they will take their distributions, there are a few strategies that can alleviate some of the ensuing income tax bill.

A spousal inheritor who is in a higher tax bracket in the years right after the owner's death than she might be years down the road should convert the inherited IRA to her own, if it delays RMDs (and taxes) for the time being.

Conversely, a spouse who is the sole inheritor of an IRA and in a lower tax bracket now versus what she might be in the future may want to convert the IRA she inherited to a Roth IRA now, and of course pay any ensuing income taxes.

Employed non-spousal beneficiaries can offset the tax bill incumbent upon RMDs or other withdrawals by increasing contributions to pre-tax at-work retirement plans or IRAs.

Distributions from non-spousal inherited IRAs cannot be converted directly to Roth IRAs. But if the distributions are not needed by the beneficiary, he can at least use the extra income to make a Roth IRA contribution, if eligible.

Beneficiaries who are eligible for Social Security may want to delay taking the government-sponsored retirement benefit, and instead draw money from the inherited IRA to cover living expenses.

Not only will the eventual Social Security check be considerably higher, but the income tax bill incurred before and after initiating Social Security will likely be lower than if the beneficiary were to receive simultaneous income from both the inherited IRA and Social Security.

Wait, There's More

Keep in mind that the beneficiary options may be different for Roth IRAs, qualified retirement plans, and if the designated beneficiary of the IRA is a trust, a charity, or the deceased owner's estate.

And if you're confused by all of this, imagine how bewildered your clients will be when confronted with the same questions, and how important you are to helping them figure out which option is best for them.


Kevin McKinley CFP is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of the book Make Your Kid A Millionaire (Simon & Schuster), and provides speaking and consulting services on family financial planning topics. Find out more at

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