Christine Benz: Hi, I'm Christine Benz for Morningstar.com. If you've inherited an IRA from a loved one, you have several important decisions to make. Joining me to discuss that topic is Ed Slott; he is a best-selling author and an IRA expert. Ed, thank you so much for being here.
Ed Slott: Thank you, Christine.
Benz: You are a real expert in IRAs and, particularly, distributions. So I'd like to discuss with you, Ed, what is a very knotty topic, and it's this idea of what to do when you inherit an IRA. And there are some important distinctions depending on your relationship to the deceased. So, let's start with the spouse beneficiary. Let's talk about what options they confront at the time in which they inherit an IRA from their spouse.
Slott: As an inheritor, I always start with two words, no matter who the inheritor of an IRA is. Two words: touch nothing.
Benz: So, go get some advice.
Slott: That will save you a fortune. Those two words. Until you are with somebody who knows how to set up IRAs, knows how to set up inherited IRAs, knows the difference between beneficiaries. Again, you need somebody with specialized knowledge in this. I'll give you an example. The average beneficiary, let's say, is a son or a daughter and they're not children; they are maybe in their 50s already. The first thing they might do [is say,] "Oh, here is Mom's $500,000 IRA--let's take it out." Well, that's the end of that. The minute you touch an inherited IRA, it's over. The minute it comes out, it's taxable. And that mistake is the number one mistake, grabbing it too fast. It's taxable, and there is no fix. That's an irrevocable--or what I'd call fatal--error. So, first thing, take a breadth. You can look at it on the statement, but don't touch it.
Now, to your question, the spouse is the beneficiary. First, we see the spouse probably knows they are the beneficiary. The spouse also probably knows how old they are. So, if they are under 59 1/2, they should maintain it as an inherited IRA--only a spouse has that option. The spouse can also do a rollover. Most people will recommend, including myself, to do the spousal rollover, but only if the spouse is 59 1/2 or older. If the spouse is younger than 59 1/2, it's more likely that spouse may need to dip into that money. And if he or she does, of course, they will pay the tax--that's not what we are talking about--but they will also pay a penalty if they do a rollover, because once they do a rollover, it's treated as if it was always their money, and they are subject to the 10% early withdrawal penalty.
If, instead, they elect to stay as a beneficiary, there is no 10% penalty. So, if they need money before 59 1/2, they can just take that money. They will pay the tax, but no 10% penalty. Then, at 59 1/2, when the penalty period expires--there's no penalty once you hit 59 1/2--then he or she can do the rollover into their own IRA and they don't have to take required distributions until they turn 70 1/2.
Another important thing for any beneficiary, but especially a spouse: As soon as you inherit, set up the right type of account. Again, if you are under 59 1/2, an inherited account; 59 1/2 or over, a spousal rollover. But immediately name new beneficiaries on your own IRA.
Benz: So, why is that so important to make sure that you are naming those beneficiaries?
Slott: For two reasons: Number one, you direct where that money will go after you die, and [number two,] to preserve or hopefully preserve the stretch IRA for your chosen beneficiaries. Otherwise, if you don't name beneficiaries, it may end up back in your estate; it could be contested; who knows where it might end up? And it might blow the stretch, the extended payout, for your heirs.
Benz: So, if your heirs are younger, they have the opportunity to stretch those distributions.
Slott: In certain cases. If you do a spousal rollover, then it's yours. And you should name both primary and contingent beneficiaries. If they are named on the IRA beneficiary form, they can stretch. If you keep it as an inherited IRA, you still want to name beneficiaries. They would be, in that case, successor beneficiaries--in effect, the beneficiary's beneficiary.
Benz: Does it matter if the deceased had begun taking distributions and was required to take required minimum distributions from that IRA?
Slott: Years ago, it used to. But now, it generally does not, other than in a few situations. Again, it's always going to come back to being very careful about not only naming the beneficiaries you want on the IRA beneficiary form--not in your will. The beneficiary form trumps, it overrides the will. If you name beneficiaries on your beneficiary form and they are individuals like your children or grandchildren, they can stretch the inherited IRA over their lives regardless of when you, being the IRA owner, died.
So, it wouldn't matter if you died before or after 70 1/2. The only time it matters if you died before or after 70 1/2 is if you've neglected to name beneficiaries. So, you don't have a designated beneficiary to the account. And in that case, many times your estate becomes the beneficiary by default. And the estate is not a designated beneficiary, so the stretch would be lost and then special rules come into play depending on when the IRA owner died, before or after 70 1/2.
Benz: Moving on, let's discuss nonspouse beneficiaries. You noted that one of the key things you should definitely think twice about is just taking the money and running, because you trigger a big tax hit there. What are the other options, apart from taking an immediate distribution, that nonspouse beneficiaries have?
Slott: Well, there is a trap even if you don't think you're taking an immediate distribution. Again, two words: touch nothing. Let's say you're the child who inherited; you are 50 years old. I use the word child but probably an adult child. And [the adult child] says, "Well, I want to invest it the way I want to invest it. My dad was too conservative. I'm going to move it from his IRA to my inherited IRA, and I'll do investing in a different place. I didn't like where we had the money for whatever reason."
So, here is a situation where they don't want to take all the money out; they just want to invest it differently. But if they take the money out and move it to their inherited IRA, first, they can't do that. Once they take the money out, that's the trap. It's exposed. It's over. It can't be fixed; the whole thing is taxable.
So, you can still move it to the investment of your choice, but it can only be moved as a direct transfer--also called a trustee-to-trustee transfer, where you never touch the money. If you take a check out of that IRA--your dad's IRA--it's over. It's taxable. It's like an egg shell: If you break it, it's over. The only way money can be moved is a direct transfer without you touching the money. That's so important. If you touch the money, there is no more inherited IRA. It's all taxable, and there is no fix for that.
Benz: So, it's important to set up an inherited IRA that's separate from other IRA assets that I might have?
Slott: Right. It has to be a properly titled inherited IRA, which means the name of the deceased IRA owner must remain in the account title. So, it would read something like "John Smith IRA, deceased, date of death, FBO"--which stands for for the benefit of--"John Smith Jr." That's a properly titled inherited IRA. That cannot be, exactly as you just said, commingled with an inheritor's own IRA. You do that, it's over. There are so many rules in the inherited area where you have a fatal error. When I say it's over, it means the entire inherited IRA becomes taxable, and it all gets added to your income in one tax year, and it's over.
Benz: So, assuming I've set up that inherited IRA separately and I'm a nonspouse beneficiary, what are my distribution options for that account after I've gone and done that?
Slott: Then, you can stretch or extend distributions over your own life expectancy, which can be fantastic. Obviously, the younger you are, the better it is. For example, if you inherit it at, say, 30 years old, you can stretch it over 53.3 years. So, you can take minimum distributions over the rest of your life expectancy--and I get those numbers from IRS tables. It doesn't matter what kind of health you are in or whether you think you are going to live long or short; these are published life expectancy tables for everyone. But you have the ability, if you set everything up right, to stretch it over your lifetime or take more if you want to. The amount you have to take is simply the minimum.
Benz: Let's talk about the rules regarding Roth assets that might be inherited. Let's talk about the key ways in which they are different and what people should know if they happen to inherit Roth assets. We usually think of that as a very good asset to inherit.
Slott: The Roth IRA is the best asset to inherit because it's tax-free. But all the rules I just talked about, whether you're a spouse or nonspouse, required minimum distributions apply to inherited Roths. This is where people get tripped up. Roth IRA owners do not have lifetime required distributions. You never have to take money out of your Roth IRA at 70 1/2, like Traditional IRA owners do. But once you inherit a Roth IRA, there are required minimum distribution that follow the same rules.
The only exception to taking required minimum distributions from a Roth is if you're a spouse. If you're a spouse and you inherit your husband's, let's say, Roth IRA, you can roll it over to your own Roth IRA and still avoid required minimum distributions until you die. But then once you die, once it goes to a nonspouse, there are required minimum distributions each year to the nonspouse beneficiary, but the big difference is that those distributions will be tax-free forever.
Benz: Ed, thank you so much for being here to share your insights. This is such an important topic. We really appreciate you taking the time out of your schedule.
Slott: Thank you, Christine, for having me on the program.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.