IRAs are among the simplest and best ways to transfer wealth to heirs.  In effect, you are not simply passing on a chunk of money, but rather a chunk of money with future tax-deferred or tax-free growth embedded.  However, if you are the beneficiary of an IRA, it’s important that you take the right steps to ensure those benefits.  Otherwise you could inadvertently lose them.

Let’s suppose that your Uncle John dies this year and leaves you his mounted butterfly collection, his 1985 Honda Civic, and his IRA.  You graciously disclaim the butterflies and the car, knowing that your cousin Marco (next in line) would get so much more pleasure from them than you would!  But the IRA, worth $20,000, is not something you choose to eschew.  You have primarily two options:

1. Immediately withdraw all the funds from the IRA and pay taxes on the distribution.
2. Establish a beneficiary IRA.

Unsurprisingly, the second choice is almost always the best one.  Why?  You not only get to defer the taxes from Uncle John’s earnings over a much longer period of time, but you get additional tax deferral on your earnings in the account until you reach your own retirement age.

Assuming you do select choice (2) above, does it mean that, because it’s an IRA, you can continue to grow it over your lifetime, start taking minimum required distributions (RMD) at age 71, and then pass on the remainder to your heirs in much the same way that Uncle John did for you?  Unfortunately, no.  The government imposes some special restrictions on beneficiary IRAs that do not apply to ordinary IRAs.  First, you have to begin taking distributions no later than December 31^st of the year following the year of your uncle’s death.  Second, you must take an amount each year proportional to the number of years remaining in your statistical lifetime.  If you’re 52 and single, for example, you have to withdraw about 3% of the IRA in the first year (or more).  The distribution amount grows each year until you reach age 84, at which point you are required to distribute the entire remaining amount.  If you die sooner, your heir has no choice but to liquidate the account and pay the taxes (choice (1) above).

Why are the rules for beneficiary IRAs different from ordinary IRAs?  Simply because the government, which has been waiting for its share of taxes from your uncle’s IRA ever since he created it, doesn’t want to have to wait any longer than one more additional lifetime (yours) for the money.  (This is still not a bad deal.  Prior to the late 1990s your only choice when inheriting an IRA was to liquidate it and pay the taxes.)

If you inherit a Roth IRA, there’s an additional twist.  As you may know, distributions from Roth IRAs are completely tax free, with one exception.  Roth IRAs have what’s known as a five year clock.  Any earnings withdrawn within the first five years after creating the Roth IRA are taxable.  This rule applies to beneficiary Roth IRAs as well as ordinary Roth IRAs.  If you’re required to start distributing a portion of your balance the first year after you inherit the Roth IRA, how can you avoid paying taxes on the distributions for the first five years?  This is where the ordering rule for distributions comes into play.  When you withdraw funds from a Roth IRA account, the IRS assumes that you are distributing the original contributions first.  Only after all the contributions have been taken are you considered to be distributing the earnings.  Contributions are never taxable for a Roth IRA since they were made with after-tax money.  So as long as the first five years’ worth of distributions does not exceed your uncle’s contributions to the account, you will never be taxed on any amount withdrawn during your lifetime.

If instead of Uncle John it was your spouse that passed away, you have additional choices as to what to do with an inherited traditional IRA or Roth IRA.  In that situation the best choice is usually to convert the account into your own IRA or Roth IRA, for several reasons:

• You don’t have to start taking distributions until you reach age 71.
• Your heirs can inherit the account as a beneficiary IRA or Roth IRA.

It’s important to follow the rules and to track the required annual distribution amount (which changes each year) if you have a beneficiary IRA or Roth IRA.  If you have a financial planner, he or she should be letting you know each year how much to withdraw from the account.  If not, you need to make the calculation yourself.  Be sure not to make a mistake: the penalty for failing to take required minimum distributions from any IRA or Roth IRA (including beneficiary IRAs) is a whopping 50% of the required amount!

See http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics—Required-Minimum-Distributions-(RMDs) for more details.