Transferring wealth from one person to another is something that might need to be done for a multitude of reasons, such as the death of a parent which then triggers a chain of events that should ultimately result in funds being passed on.
However, an inherited IRA is one particular transaction that can go badly wrong and could easily become far more complicated than necessary, if the right steps are not taken and all the paperwork is not filed correctly.
It is fair to say that what should be one of the most straightforward financial transactions, in theory, can end up becoming far more complicated and stressful than it should be, which is why it is worth following some simple steps to help ensure that everything goes as smoothly as possible.
It is also well worth remembering that if the transaction is not handled correctly it could result in a large tax bill that could potentially have been avoided.
Become a designated beneficiary
When you inherit an IRA and the wealth is intended to be transferred to you it is a primary benefit to be named as the designated beneficiary.
What this means is that you are named on the IRA account as a designated beneficiary and this creates a number of tax benefits and distribution options, depending on the age of the original IRA owner when they passed away.
Get professional advice on achieving this status and always remain mindful how important this aspect of the transaction is.
Take your time
A solid tip to follow at all times when it comes to something as important as an inherited IRA is to never be in a rush to get some paperwork filed or signed.
It is much better to get everything properly reviewed and ensure that you are happy with and understand all aspects of the transaction before you sign or file anything.
Don’t be tempted to cash anything too hastily either, as it is often much better to take a step back and wait until you and your professional team who is handling the transaction are completely satisfied that everything is in order.
Bear in mind that tax benefits can be gone forever once you have chosen to distribute cash, and that should help highlight the importance of showing patience and diligence in these circumstances.
There can be more than one beneficiary
Another key step in the process is to identify whether there is going to be more than one beneficiary named on the IRA.
If this is the case, you need to be aware that there is a deadline that needs to be adhered to for splitting the IRA.
Designated beneficiaries need to named by the 30th September in the year following the death of the original IRA owner.
You will then have until the 31st of December, three months later, to complete the split.
Get the title right
Most steps in the process of transferring an IRA can be considered important but setting up the inherited IRA correctly has to be considered one of the most vital elements of the whole transaction.
An inherited IRA still has to contain the name of the original owner, so get professional guidance on making sure that you end up titling the new IRA correctly, otherwise it can cause administrative issues going forward.
Get the numbers right
Next on your list should be the task of calculating the correct distribution amount.
You will need to get a year-end value and provide a one-time life expectancy figure using IRS Life Expectancy Tables.
IRS Publication 590-B provides the guidance and figures that you will likely need to get this information correct.
You will discover that even when the inherited IRA is a Roth IRA, beneficiaries will still be required to take minimum distributions and as with most aspects of this type of transaction you will need to follow a strict set of rules and observe distribution requirements and options.
Find out about any after-tax basis in the IRA
This is one particular aspect of the whole transaction that is most likely to be overlooked more than others.
If you are a beneficiary and after-tax contributions are applicable you will be required to file IRS form 8606 in order to be able to claim the non-deductible portion of the specified minimum distribution figure.
It is quite common to discover that an IRA beneficiary has either not had the inclination or the motivation to establish whether the IRA they invented has an after-tax basis or not.
It is always worth asking the question and checking old paperwork to determine the answer to this important question.
Have a plan
It is often much better to be proactive rather than reactive when it comes to tax planning and making the most of any allowances or eligibility criteria that you could take advantage of fairly.
Aim to plan for the taxation of distributions and arrange to get a calculation of the distribution before adding the taxable portion to a tax projection, so that you have a clear idea of how much tax you can withhold.
As you can no doubt see from some of the key steps and issues highlighted there are numerous tax traps that await you in this situation, and when you act in haste or without the advantage of knowledge that comes with getting professional guidance, you could easily end up wrecking your chances of enjoying allowable tax breaks for many years to come.
Inheriting an IRA is an opportunity to distribute wealth and secure a better future, which is why it is so critical to take all the required steps and precautions to be sure that you have maximized the opportunity from a tax point of view.
Keep at the front of your mind the prospect that a false step could result in a severe 50% IRS penalty and that should provide you with all the motivation you need to be very diligent when you become an IRA beneficiary.
