An inherited IRA can be a complex issue. There are numerous inheritance options for taking care of the family after an individual has passed on; it’s confusing what exactly should be passed down.
An inherited IRA is clearly designed for beneficiaries after the procurer dies. These are retirement plans that are passed on for a leg up on retirement for the beneficiary.
There are pros and cons to inherited IRAs. One of them is that the account continues the retirement account’s tax-deferred growth. This means there is no tax paid until withdrawal. No taxation on the account while it is growing.
Benefits
This can be a major benefit because there is no tax paid upon contribution to the account. The beneficiary will only have to pay taxes one time unless of course, they pass on the account to a beneficiary of theirs.
Contribution requirements vary by provider or banks. The inherited IRA is like any other account in that it will incur penalties if the required minimum contributions aren’t met and contributions to the account start Dec 31st of each year for many banks.
Taxes really determine how inheritance works for a lot of people. The IRAs have no immediate impact on the income tax charged to the account holder. During the tax filing process, no income tax can be charged to the IRA contributions when filing the taxes by April 15th.
This is good because it saves the account from being taxed upon contribution and withdrawal. That helps the account holder from having to pay the massively high percentage in taxes up to several hundred times.
Another benefit is that anyone can take over contributions during their lifetime as long as that individual is a beneficiary or a designated guarantor on the account.
Generally, the beneficiary must take over the contributions during their lifetime within five years of the account holder passing away.
For the open inherited IRA, there are several things to know. Your annual distributions are spread over your single life expectancy, which is determined by your age in the calendar year following the year of death and reevaluated each year.
If multiple beneficiaries, separate accounts must be established by 12/31 of the year following the year of death; otherwise, distributions will be based on the oldest beneficiary. The beneficiary will not incur the 10% early withdrawal penalty. Undistributed assets can continue growing tax-deferred. The beneficiary may designate his or her own IRA beneficiary.
In this day and age, people are so caught up in the gleam of money, some of them will never try to pass it on another generation and they will take the money for themselves and do the lump sum distribution after the account holder has passed. This can be nice when the beneficiary needs the money in a pinch, but there is one huge drawback. That huge drawback is the possibility of moving up a tax bracket because it is considered income. This puts the beneficiary at being taxed at a higher rate.
The inherited IRAs can be referred to as “stretch IRAs.” A stretch IRA isn’t an official term, but it is a reference to extending or “stretching the financial lifetime of the IRA. This helps turn the small amount of money into a lifelong safety net, not only for the account creator but the possibly long line of beneficiaries on the account.
Disadvantages
Now, on top of the minimum contributions, there are minimum distributions required once the IRA has been inherited. That can be a perk because it is required to take money from the account, but it can be a huge con for people who want to continue growing the IRA. These are called Required Minimum Distributions and each distribution (withdrawal) is taxed.
That is where the first downside comes in; the account must be “drained” in order to exist. This is why there are RMDs. The RMDs can be taken out though and turned right back around and put back in that amount plus a little more. This is the result of inherited IRAs going to anyone except the widow or widower.
“If your husband passed away, you would inherit that IRA as if you were your husband. If you were not interested in taking money out at this time, you could let that money continue to grow in the IRA until you reach age 70 1/2,” says Frank St. Onge of Bankrate.com.
For higher income levels that are subject to the estate tax, there can be a benefit to paying the estate tax on the account. For estates subject to the estate tax, inheritors of an IRA will get an income-tax deduction for the estate taxes paid on the account. The taxable income earned (but not received by the deceased) is called “income in respect of a decedent.”
Another downside is the forms that the beneficiary must complete. They can be very simple, but this has thrown people off and lead to numerous beneficiaries filling out the documents and receiving the lump sum without intending to drain the account in one fell swoop.
The legal ramifications of trying to list the beneficiary as a trust can be complex. Numerous account holders have tried to list a trust as the beneficiary to aid the human beneficiary to not spend all of the money too quickly. The problem with this is the slightest error can cause a major problem and limit the options of the human beneficiary greatly.
Inherited IRAs can be quite wonderful for passing on money and security for beneficiaries. There are numerous benefits as well as numerous downsides. The biggest downside is the legal ramifications of filling out the official forms.
The inherited IRAs tax-deferred approach is very beneficial for the account holder, which stops the account from being taxed, and stops the account holder from being taxed on contributions during the income tax filings that must occur every year.
Do not let the downsides prohibit you from creating an inherited IRA. Also, don’t let the benefits keep you blind to the downsides. Determine what is best for you and your family by carefully weighing the options.