Inheriting an IRA can be a great source of additional income, but the penalties for mismanaging one are severe.

There are strict guidelines regarding distributions from inherited IRAs, and you want to avoid making mistakes. According to the IRS, taxpayers paid over $3.6 billion in penalties on qualified retirement plans for the 2004 tax year.1

For Spouses

If you inherit an IRA from a spouse, you can roll the assets into your own IRA and delay withdrawals until you reach age 70½. Or you can keep the IRA in the decedent’s name and remain the beneficiary, in which case you must start taking required minimum distributions (RMDs) by December 31 of the year in which the spouse would have turned 70½, or by December 31 of the year after the year in which the spouse died (whichever is later). Withdrawals taken prior to age 59½ are subject to a 10% federal income tax penalty, in addition to ordinary income taxes.

For Everyone Else

A nonspouse heir who doesn’t elect to cash out and pay income taxes on the entire distribution right away must treat the IRA as a beneficiary IRA. The age 70½ distribution rule does not apply to nonspouses. RMDs must begin by December 31 of the year following the year of the original account owner's death.

Failing to withdraw the required minimum amount results in a 50% federal income tax penalty on the amount that should have been withdrawn. If a nonspouse heir mistakenly rolls an inherited IRA into an existing IRA, it would trigger immediate income taxes and an excess contribution penalty.

Of course, you can always withdraw more than the minimum amount at any time; ordinary income taxes are owed on all distributions from a traditional IRA. Taking a large distribution in any given year could raise your income tax bracket.

By stretching distributions over your lifetime, you can postpone current taxes on the account balance, increase the time that any earnings accumulate tax deferred, and possibly grow your inheritance. If you or your heirs want to learn more about how to treat an inherited IRA, we can help.

1) Internal Revenue Service, 2006

Handling Hand-Me-Down Dollars