There are many things on the to-do list when closing out a parent's estate. While going through the grieving process, you must make financial decisions on the best ways to deal with estate and income taxes. Being the beneficiary of a parent's IRA has special tax considerations.
Consider the Estate
You might not be the executor of the estate, thus not responsible for dealing with the assets, income and debts. The IRA avoids probate, thus you have access to the funds immediately and without approval of probate courts or trust administrators. As such, the IRA is not part of the estate that creditors can attach liens on. However, the inherited IRA is considered part of the estate for federal tax purposes. If the estate is over $5 million, everything is taxed at 35 percent in federal estate transfer taxes as of 2011. Estates not meeting the $5 million threshold have no estate transfer tax issues.
Your Inherited IRA Options
When an estate, trust or will is named as the beneficiary, the IRA must be liquidated and dispersed according to the documents providing the IRA owner's desires. However, if you are named as the beneficiary, you have three options. The first is a lump-sum distribution, taking all money out at once. The second is the five-year distribution period, taking equal payments out. The last is rolling the inherited IRA into a beneficiary IRA so you can continue the IRA structure with only minimum distributions required. Make sure you take out any Required Minimum Distribution before Dec. 31 of the year following the death to prevent a tax penalty.
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Choosing Your Best Option
Each situation is different; speak with a tax adviser if you are concerned or confused about the implications of any choice. Taking a lump-sum distribution out of a traditional IRA adds the entire distribution to your income taxes. This can increase your income tax bracket, thus causing greater taxes on your standard income sources plus the inherited amount. Roth IRAs have no tax implication on distribution as long as the IRA is owned for at least five years prior to distribution. If your parent didn't own the IRA for five years, the earnings are added to income until the five-year rule is met. The five-year distribution rule helps in both situations, reducing the amount added to income in any one year with traditional IRAs and buying more time to fulfill Roth IRA rules. The beneficiary IRA offers a special stretching structure.
Beneficiary IRA Structure
A beneficiary IRA simply takes your parent's IRA and rolls it into a beneficiary IRA. A traditional remains a deferred IRA while a Roth remains a tax-free structure. The beneficiary IRA must distribute a RMD each year based on your age, not your parent's. You are younger than your parent, which means your RMD is less than what your parent's was. This structure allows you to still invest the assets, growth them without tax consequence and take minimum distributions preserving the asset for years to come. Regardless of your age, there are no penalties for distributions; traditional distributions are added to your income and Roth distributions meeting the five-year mark are tax-free.