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As the first generation of investors in traditional individual retirement accounts begin to die, an increasing number of surviving spouses or children are inheriting those IRAs. Unfortunately, in the process many inheritors are making irreversible mistakes that can cost them thousands of dollars in extra taxes and lost potential earnings.

First, it’s important to understand that the inheritance rules for traditional IRAs (versus Roth IRAs) differ for surviving spouses and non-spouses such as children or siblings, and when the inheritors are designated as IRA beneficiaries or if no beneficiaries were designated.

Let’s start with spouses. Spousal rules. A surviving spouse has three options when inheriting an IRA from his or her deceased spouse. First, the spouse can simply cash in some or all of the IRA and pay income tax on the withdrawal. Second, the spouse can leave the IRA in the deceased’s name, or third, roll it over into an account in the survivor’s name.

The decision will be influenced in large part by the survivor’s age, the age of the IRA owner at the time of death, whether required withdrawals had already begun, income requirements, and other financial circumstances.
Let’s say the inheriting spouse is younger than age 59 1/2 and needs money from the IRA for household expenses. If the survivor leaves the IRA in the deceased’s name, he or she can make withdrawals before age 59 1/2 without paying the ten percent early withdrawal penalty, though ordinary income taxes will still be due. But if the spouse rolls the IRA into his or her own IRA, then any early withdrawals usually will be subject to the penalty.

On the other hand, it usually makes more sense for inheriting spouses age 59 1/2 or older to roll the IRA over into their own IRA or re-title the inherited IRA in their own name. This makes it easier to manage, allows them to name new beneficiaries, and allows those new beneficiaries to “stretch” distributions when they inherit. There is an additional benefit for survivors who have not yet reached age 70 1/2. In situations where the deceased spouse had already begun making required minimum distributions (no later than April 1 of the year following age 70 1/2), the inheriting spouse must continue making withdrawals based on what would have been the deceased’s life expectancy. But by rolling the IRA over into the survivor’s own account, he or she can delay distributions until shortly after they turn 70 1/2. Then distributions will be based on the heir’s life expectancy.

Non-spouse rules. Inheriting IRAs is more limited for non-spousal heirs. If the IRA has no designated beneficiary, and the owner had already started required distributions, then the heir must continue taking out distributions based on the owner’s remaining single life expectancy at death. If distributions had not started, the heir must take all the money out within five years and pay ordinary income taxes. The withdrawals are, however, exempt from the early withdrawal penalty, even if the heir is younger than 59 1/2. If the IRA did designate a non-spouse beneficiary, then that person can take annual minimum withdrawals based on his or her own life expectancy regardless of whether the owner had already started required distributions. Unlike spouses, non-spouses cannot roll an inherited IRA into their own IRA. But by establishing a “beneficiary IRA”—sometimes called a stretch IRA, dynasty IRA, legacy IRA, or other names—the inherited IRA remains in the name of the deceased but for the benefit of the heir. A typical titling for the IRA might read: “Jane Smith, deceased, IRA, for the benefit of Son John.” Multiple non-spouse heirs, by the way, such as a brother and sister, can split the inherited IRA into separate IRAs. If they don’t split it, then the minimum withdrawals are based on the life expectancy of the oldest heir, which obviously may not be to the benefit of the younger beneficiary or beneficiaries.

As can be seen, inheriting an IRA can be a tricky business, even for many financial service providers, so don’t make any decisions before consulting a financial professional who is very familiar with the IRA inheritance rules. Caution: not all IRA custodians allow all of these options, even though federal law does. In such cases, you may need to change custodians.

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Before you learn about stretching your Inherited IRA, you need to understand IRA basics.  IRAs have been around for years.

Traditional IRAs allow you to invest a certain amount of before-tax earnings on a yearly basis. That reduces your current taxes because you don’t pay taxes on that money until you actually take it out later. The main benefit of your IRA is that it grows more quickly because you aren’t taking money out to pay taxes.

Company retirement programs like 401(k)’s work similarly. Sometimes companies will match a portion of their employees’ contributions, dramatically increasing the employee’s return. If your company matches any of your contribution make sure you take advantage of it!  When you change jobs or retire you can transfer the money from your 401(k) into your own IRA.

Roth IRAs allow you to invest after-tax dollars, but the earnings on a Roth IRA are never taxed.  You aren’t required to start taking money out of a Roth IRA at age 70 ½ like as in a traditional IRA.