What to know about inheriting an IRA

Are you named as a beneficiary of an IRA owner? If so, you'll need to understand the rules that govern IRA inheritances and how good intentions can lead to bad tax results. Here's a recent real-life example.

When a son found out he was the beneficiary of his deceased father's IRA, he did what he thought was in keeping with his father's wishes: to have all three of his children equally share the IRA. But only this son was listed as a beneficiary, so he requested a distribution of the IRA of approximately $100,000.

He then split that amount with his two siblings and deposited what he believed to be his share. He did this thinking he was following the advice of his attorney, who assured him that there would be "no tax" on the IRA distribution. So, when he filed his tax return, he didn't include the $100,000 IRA distribution in his gross income.

That led the IRS to flag the son's tax return for underreported income because none of the IRA withdrawal was included in his gross income. The agency issued a notice of deficiency, saying all $100,000 was part of the son's gross income, resulting in a significant liability for federal tax, interest and penalties owed solely by the son.

The son decided to take his problem to Tax Court and posed two arguments. First, because his attorney said no tax was due on the IRA, he thought the withdrawal would be tax-free. The Tax Court noted that the paralegal at the firm who gave the advice meant there would be no federal estate tax or Michigan inheritance tax due regarding the IRA distributions, but provided no advice regarding the son's personal federal income tax matters.

Second, the son argued that it wouldn't be fair to hold him solely liable for the income tax on the $100,000 because he voluntarily shared two-thirds of it with his siblings, and he was unlikely to recover any of this tax from them.

Unfortunately for the son, both arguments fell on deaf ears. The Tax Court found no relief for him.

This story has two morals: First, had the father updated his IRA beneficiary designations to reflect his three children to share equally, one of the son's tax problems could have been easily avoided. Second, if you're the beneficiary of an IRA, do not take any withdrawals until you know the rules for withdrawals and rollovers regarding inherited IRAs.

Note that only a spouse beneficiary of an IRA has the option of rolling the assets into her own IRA. So, if you're not a spouse, you generally have three options:

Direct transfer of the IRA to a special type of IRA called an inherited IRA, disclaim your share of the IRA or take cash distributions as taxable income. Most people choose the first option. To do that, here are the steps to take.

First, you'll need to open a special type of IRA, called an inherited IRA, or a beneficiary account IRA. When you establish one, it's important that the IRA custodian registers the account properly. The account registration should include the name of the person who died, an indication that the account is an IRA beneficiary distribution account and the inheritor's name.

Different IRA custodians may have varying interpretations of the IRS rules and may require all or some of this information.

Make sure any assets transfer directly from one account to another, or from one IRA custodian to another. There's no option for a 60-day rollover when inheriting IRA assets. If you receive a check, the money will be taxed as your ordinary income, and it can't be deposited into an inherited IRA you may own at another firm. Also, once you take a check, it can't be deposited back into the inherited IRA that it was withdrawn from to begin with.

If you don't have an immediate need for the money, leaving the assets in the inherited IRA until minimum distributions are required may be the best move because the longer you keep the money in it, the longer you will enjoy tax-deferred growth. On the other hand, when you take money out of an inherited IRA, it will be taxed as ordinary income.

What if you decide the IRA is too small to deal with, or if you would rather have your share go to other beneficiaries? You can file a qualified disclaimer to decline all or part of the IRA assets you're entitled to. If you do this, your share will pass to the other eligible beneficiaries. If no other beneficiaries exist, the assets will pass to the original IRA owner's spouse. And if no surviving spouse, then to the estate.

You must decide to disclaim IRA assets within nine months of the owner's death and before you take possession of the assets. Also note: Declining your share of an IRA is irrevocable.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.