More Must-Knows About Inherited IRAs

This article originally appeared in January 2011. In case you missed it, we're running it again as part of our IRA Improvement Week.

When I originally wrote about inherited IRAs, poster deeclu really nailed it with this comment: "A complex subject and not easily addressed in a two-page article." Poster pete228 astutely opined, "One really has to be careful when messing around with this stuff."

Alas, there's still much more to know about inherited IRAs than the scenarios I addressed in my article. What if the beneficiary is a minor child or an estate? What if there's no beneficiary at all? How does it work if the beneficiary doesn't need or want the IRA assets and would like to pass them to other heirs instead?

And while my article discussed the options available to those who inherit IRAs, some of you noted that you'd like to see more color on which of these distribution strategies is the most desirable one if you've inherited an IRA.

I'll tackle some of these loose ends here, and I appreciate that several users weighed in with their own insights and questions on inherited IRAs in the comments below my original article.

No Beneficiary Designation?
The scenarios I outlined in my article were all ones in which an official beneficiary had been named for an IRA. But what happens when an IRA doesn't have a beneficiary? The answer is, it depends. It's up to each custodian--that is, the financial institution where the IRA is held--to lay out the ground rules. Some firms pass remaining IRA assets to a surviving spouse and, if there is no surviving spouse, to the deceased person's estate. Other firms pass the assets directly to the estate. Because there's no one set standard that you can rely on, it's crucial to name primary and secondary beneficiaries for all of your IRA and retirement accounts to ensure that your assets are distributed in accordance with your wishes.

Estate Is the Beneficiary
If an estate is the named beneficiary of the IRA, or if the IRA assets pass directly to the estate because there's no named beneficiary, that's often less desirable than naming an individual as the beneficiary of the IRA. Whereas individual beneficiaries may have the opportunity to stretch out the tax-saving benefits of the IRA over many years, there are fewer mechanisms available when IRA assets pass to an estate. If the deceased had not started taking required minimum distributions from his or her traditional IRA account, the assets must be distributed by the end of the fifth year following the account owner's death. If the deceased had begun taking RMDs, the assets must be distributed in line with the deceased individual's own RMDs, if not sooner. And if the deceased hadn't yet taken his or her RMD for the year of death, that distribution must be paid out as soon as possible.

Charity Is the Beneficiary
For those who are charitably inclined, making a charity the beneficiary of a traditional IRA can be gratifying, and it can also be a very savvy tax move. While your heirs may be able to stretch out the tax-saving benefit of a traditional IRA over a period of years, as outlined in my previous article, they'll still owe taxes on the money they take out. By contrast, qualified charities will not owe any taxes on gifts they receive, essentially negating the tax liability attached to those traditional IRA assets. In addition, leaving IRA assets to charity allows the estate to receive an estate-tax deduction on the federal estate-tax return.

A Minor Child Is the Beneficiary
Naming a minor child as the beneficiary of an IRA is a big mistake, as estate-planning attorney H. Susan Jones noted in this interview. That's because minor children can't own assets outright, meaning that a court-appointed guardian must administer the assets on behalf of the child. If you're seeing dollar signs--and aggravation--you've gotten the picture of why this isn't a good idea. If you'd like to leave IRA assets to a minor, check with an estate-planning attorney about setting up a trust or a UTMA/UGMA account.

Disclaiming an IRA
If the person who inherits an IRA doesn't need or want the assets, she can decline to be the beneficiary within the first nine months of the account owner's death. The assets would then pass to the next eligible beneficiaries. This maneuver can ensure that the assets pass to the loved ones who truly need the money. It can also help save on taxes if the secondary beneficiary is in a lower tax bracket than the individual who originally inherited the assets, or if the secondary beneficiary is a younger person who can take distributions over a longer time period than the original beneficiary.

However, bear in mind that declining the assets also means declining any future control over them. If a primary beneficiary would prefer that someone other than the secondary beneficiary inherit the assets, the only workaround is for the primary beneficiary to claim the assets, then redistribute to the individual(s) she chooses. However, the primary beneficiary would owe taxes and be subject to rules regarding RMDs.

Lump Sums and Stretches
My original article noted that you can always choose to take a lump-sum distribution from an inherited IRA. In so doing, you'll get your hot little hands on the money, and you won't be subject to the complicated distribution rules that govern inherited IRAs in most other situations. However, the big downside is that you'll be forking over all the taxes due to the IRS at one time, rather than doling them out over a period of years (and thereby hanging on to, and potentially earning interest on, the money) as you can do with other inherited IRA-distribution methods.

That's where the "stretch IRA" comes in, which several of you advocated for in your comments on my original inherited IRA article. You can't go to Vanguard and tell them you want a stretch IRA. Rather, stretching is a strategy that lets the person who inherits assets take distributions based on his own life expectancy. The younger the person, the longer the potential stretch.

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