Inheriting Uncle Henry's IRA

The tax rules are tricky when it comes to inheriting an IRA from someone other than your spouse. Here's a tutorial.

In a related article, I explained how the IRA minimum withdrawal rules affect spouses who inherit their husband's or wife's IRA. But what if you inherit your Uncle Henry's IRA, or any IRA that belonged to someone other than your spouse? Well, those rules are different. And it's important to understand them, since if you fail to take minimum withdrawals according to IRS guidelines, you can be socked with a penalty equal to 50% of the shortfall. And your Uncle Henry didn't spend all those years saving for that.

So do him a favor and pay attention here. Trust me, the payoff will be well worth it.

Scenario 1: Uncle Henry dies before April 1 of the year after he turned 70½
Still with me? I know the title above is confusing. But basically what you need to know is whether the IRA owner turned 70 1/2 last year. And if he did, did he die before April 1 of this year? If so, you fall under this scenario. You're also in this camp if Uncle Henry was younger than 70 1/2 when he passed away.

Under the new rules, a nonspouse beneficiary named by the deceased account owner in this situation must begin taking minimum withdrawals over the beneficiary's life expectancy. (You can, of course, always take out more than that if you'd like, just keep an eye on how that might affect your tax liability for that year.) The first withdrawal must occur by Dec. 31 of the year following the year the account owner dies. In subsequent years, additional minimum withdrawals must be taken by Dec. 31 of each year. These withdrawals are required in order to avoid the 50% penalty.

So how do you know how much you need to withdraw? You need to crunch the numbers by dividing the account balance at the end of the previous year by your life expectancy. You can look up your life expectancy using Table I in Appendix C of IRS Publication 590. (Individual Retirement Arrangements), which is available on the IRS Web site.

Example 1:
Say your beloved Uncle Henry died in 2004 at age 68, and you're the sole designated beneficiary of his traditional IRA. You must take the initial minimum withdrawal by the end of 2005. Until then, you can leave the account untouched, which from a tax perspective, is a smart thing to do since it allows the account to grow tax-deferred (or tax free, in the case of a Roth IRA). To figure the minimum withdrawal amount for 2005, you must first determine the appropriate life-expectancy divisor to use. That depends on your age as of the end of 2005. Let's assume you're 48 on Dec. 31, 2005. Using Table I, you'll find the single life expectancy for a 48-year-old person is 36.0 additional years. Now divide the Dec. 31, 2004, account balance, say $250,000, by 36.0 to come up with your 2005 minimum withdrawal amount of $6,944. You must take out that amount (at least) by Dec. 31, 2005, to avoid the 50% penalty.

Your 2006 minimum withdrawal must be taken by Dec. 31, 2006. The amount will equal the Dec. 31, 2005, account balance divided by 35.0 (the single life-expectancy figure for someone age 48 minus 1.0 because you are now a year older), and this pattern will continue on for each subsequent year as long as you live. The same drill applies if you inherit Uncle Henry's Roth IRA or SEP account.

Exception:
In this scenario, you do have one other option: the so-called five-year rule. It simply requires you to completely liquidate the inherited account by no later than Dec. 31 of the fifth year after the year the original account owner dies. Until that date, you can withdraw as much or as little as you wish. For example, if Uncle Henry died in 2004, you'd have until Dec. 31 of 2009 to liquidate his account and pay the resulting tax hit, under the five-year rule. But if you don't need all that money over the next five years, following the five-year rule isn't the tax-smart choice. Why? Because you'd forgo the many additional years of tax-deferral advantages allowed if you choose to gradually liquidate the account over your life expectancy. Of course, in some cases beneficiaries have little choice but to use the five-year rule, should the IRA trust document require it.

Scenario 2: Uncle Henry dies on or after April 1 of the year after turning 70½
In this case, you simply follow the procedures explained above in Scenario 1. In other words, you must take your initial minimum withdrawal by Dec. 31 of the year after the year the account owner dies using your own life expectancy to calculate the minimum withdrawal amount. The only difference in this scenario? The five-year rule isn't an option. You must also arrange for the deceased account owner's final withdrawal by Dec. 31 of the year of death. That amount is calculated as if the account owner were still alive at year-end, using the taxpayer-friendly rules explained in the article Understanding the IRA Withdrawal Rules.

Once again, the same rules apply if you inherit a Roth IRA or SEP account from the original account owner.

Scenario 3: You inherit an IRA from late Uncle Henry's deceased spouse
OK, the key here's whether the spouse -- let's call her Aunt Sophie -- treated the IRA as her own, or whether it was left in the original account owner's name (specifically, Uncle Henry, Aunt Sophie's deceased husband). What's the difference? Well, as I've discussed in a related article, in many cases the spouse might want to take over the account as her own, since it offers more options, such as delaying minimum withdrawals (assuming the spouse is younger than the account owner) and switching the beneficiary.

So what happens if the original account owner's spouse inherited the IRA and treated it as his or her own and you then inherit the account when the spouse dies? In this case, you simply follow the rules explained earlier -- only based on the spouse's date of death, not the original owner's. In other words, consider the spouse as the original account owner and follow the guidelines for either Scenario 1 or Scenario 2, depending on whether the spouse died before or after the April 1 magic date. However, if the inherited IRA is a Roth account, follow the Scerario 1 rules above, no matter how old the spouse was when he or she died.

But what if the spouse did not treat the IRA as his or her own and you inherit the account before any minimum withdrawals were required? Here you should follow the rules explained in Scenario 1 using the spouse's date of death. This means your initial minimum withdrawal must be taken by Dec. 31 of the year after the year the spouse dies. You then use your life expectancy as the divisor to calculate minimum withdrawal amounts. The five-year rule is also available in this case (or may be mandatory, as explained above.)

Now, if you inherit the account after minimum withdrawals have started and the spouse didn't treat the account as his or her own, then follow the procedure explained in example 2 below.

Example 2:
Say Aunt Sophie dies in 2005. Had she lived, she'd have been 73 years old on Dec. 31, 2005. Aunt Sophie was the sole beneficiary of an IRA owned by her deceased husband, Uncle Henry. Aunt Sophie didn't treat the account as her own, and she'd begun taking required minimum withdrawals before she died. You then inherited the account, because Uncle Henry named you as the sole successor beneficiary in the event of Aunt Sophie's death.

Your first order of business is calculating the minimum withdrawal for the year of Aunt Sophie's death (2005 in this case). You must arrange for that amount to be withdrawn by Dec. 31, 2005, in order to avoid the 50% penalty. (If Aunt Sophie withdrew anything in 2005 before she died, the required minimum withdrawal amount is reduced accordingly.) So here goes.

The 2005 minimum withdrawal equals the Dec. 31, 2004, account balance divided by 14.8 (the life expectancy divisor for a 73-year-old person from Table I in Appendix C of IRS Publication 590).

In 2006, you must take another minimum withdrawal by no later than Dec. 31, 2006. The amount will equal the Dec. 31, 2005 account balance divided by 13.8 (14.8 -- 1.0, because the calculation is being made for the year after the year Aunt Sophie died). To calculate minimum withdrawals for later years, the life expectancy divisor is reduced by 1.0 for each passing year. So the divisors used to calculate your 2007 and 2008 minimum withdrawals will be 12.8 and 11.8, respectively. You get the idea.

The same procedure applies to an inherited Roth IRA or SEP account.