What can you do with an inherited IRA?

Recently, the Senate Finance Committee proposed to make all heirs take all of the money out of inherited IRA’s within five years after the date of death of the original owner of the account. This proposal was abandoned shortly thereafter, which would have changed the current system which allows the beneficiary to stretch withdrawals from the inherited IRA across their own life expectancies, allowing the assets in the inherited IRA to grow tax deferred for decades.

Many times in doing estate planning, the owner of the account will make the beneficiary designation be his or her revocable trust. The problem is that the plain vanilla living trusts may be required to take the entire amount of the IRA out within five years. This is because the trust isn’t considered a person, so it has no life expectancy and cannot take advantage of the opportunity to stretch the withdrawals out over decades. In recent times, there have been some IRS regulations which allow a trust to be seen as the conduit or “see-through” trust for this purpose. This means that the trust is merely a conduit for the ultimate beneficiaries of the trust, which allows the trustee to pass the IRA over to the beneficiaries in inherited IRA accounts that are titled in the name of the deceased f/b/o each beneficiary’s name. Each beneficiary then has the ability to postpone withdrawals from the IRA for a longer period of time. It is important to have the proper language in the trust to demonstrate that the trust qualifies as a “see-through” trust.

In the event that the IRA was taxed in the decedent’s estate, and a federal estate tax was paid, then the IRA beneficiary can get a tax deduction paid for the estate tax paid on the IRA’s value, even though the estate paid the tax. It is important for a beneficiary to ask whether there was a federal estate tax paid on this amount. In this current year, the size of the estate would have to exceed $5.12 million to result in taxation. If Congress fails to act by the end of 2012, the federal exemption will revert to $1.0 million, resulting in many more taxable estates.

In the case of wealthy adult children, they may be able to disclaim an inherited IRA, thereby passing it on to their children. The disclaimer must be accomplished within nine months after the date of death of the owner of the account.

This area is so complex that you need to consult an attorney with expertise in this area to be properly guided through the morass of tax issues.