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By Christine Benz | 12-10-2014 09:00 AM

Inherited an IRA? Don't Fall Into the Tax Trap

IRA inheritors should touch nothing until they understand the tax consequences, which can be irrevocable, says IRA expert Ed Slott.

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.

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