The Complexities of Inherited IRAs

So Aunt Edna has passed away, and left you her $850,000 IRA.  Other than being thankful, what do you do now?

As the beneficiary of her IRA, you could simply request a check and put the cash in the bank.  However, you’d best set aside a sizeable chunk of it for taxes (think $350,000 just for the Feds), as 100% of this distribution will be taxable as ordinary income (provided Aunt Edna didn’t have non-deductible contributions and an established cost basis).

If you’d rather continue the tax deferral of the inherited assets in an effort to maximize its potential lifetime value to you, you do have options.

If Aunt Edna had a Required Minimum Distribution of her own to take in the year of her death and had not already taken it, the RMD should be distributed prior to distributions to beneficiaries.  Assuming you weren’t married to Aunt Edna and are, therefore, a non-spouse beneficiary, step one for you is to open an Inherited IRA to receive the assets from her IRA.  Your options are then fairly simple:

  • Take distributions over no more than five years, or
  • Take distributions over your remaining life expectancy.

The five year rule would require you to withdraw 100% of the IRA by December 31st of the year containing the fifth anniversary of the owner’s death.  For example, if Aunt Edna died in early 2015, you would have until December 31, 2020 to distribute 100% of the account.  You would be allowed, but not required, to take distributions prior to that date.

In order to most effectively soften the tax bite, taking distributions over your remaining life expectancy is the prudent course of action.  The amount you are required to distribute will depend on your age in the year following the year of Aunt Edna’s death.  Using the IRS Table I (Single Life Expectancy For Use by Beneficiaries), determine your life expectancy, and use this number as a divisor applied to the previous year-end balance.  In subsequent years, reduce your prior year’s life expectancy by 1 and use the new year-end balances until the account has been fully distributed.

For example, if Aunt Edna died in early 2015, you must take an RMD by December 31, 2016.  You turn 57 in 2016, so have a life expectancy of 27.9 years.  The balance of the Inherited IRA as of December 31, 2015 was $850,000, so we divide this by 27.9 to determine your 2016 RMD of $30,465.95.  The balance of the Inherited IRA as of December 31, 2016 has grown to $865,000.  In 2017 we subtract 1 from the prior year’s life expectancy and divide $865,000 by 26.9 to determine a 2017 RMD of $32,156.14.  And so on…

Two items of note:

  • If you do not take an RMD by December 31st following the year of the IRA owner’s death, you have foregone the opportunity to stretch distributions over your life expectancy, and are subject to the five year rule.
  • The life expectancy factor for calculating an Inherited IRA RMD is, indeed, reduced by 1 in years following the initial year of distribution. This is very different from the factors used for regular ol’ Traditional IRA RMDs, in which a person revisits the life expectancy tables to determine their then current life expectancy.  If there are mistakes made in calculating Inherited IRA RMDs, this seems to be the most common.

Inheriting an IRA can be a tremendous blessing, but can turn into a curse if certain IRS rules aren’t followed.

Barry Nelson

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Established in 1984, Capital Financial Planners, LLC is an independent, fee-based investment management and financial planning firm located in Salem, Oregon. We provide wealth management and advisory services to clients in the Pacific Northwest and beyond. Our services include retirement planning, investment management, advisory services for trustees, hourly financial planning and more. We take a holistic and collaborative approach, working not only as our clients’ financial advisors, but as their financial partners.

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