There are many financial decisions that a widow has to face in the earlydays after the loss of a spouse. Deciding how to handle the assets that come toyou from Traditional Individual Retirement Accounts (IRAs) that were owned byyour spouse is one of them. The rulescan be complicated, and making an uninformed decision may result in having lessof the money that was left to you to support yourself and your family. While we suggest that you consult with bothtax and financial advisors to help you make the best decision, here are a fewthings to know.
There are four main options a widowed spouse can make when it comes to inheritingTraditional IRA assets as a direct beneficiary (i.e. not through a trust). Those options are:
1. Rollover assets into an IRA in your name
2. Rollover the assets into an Inherited IRA account
3. Take the assets out for spending
4. Convert the assets to a RothIRA
A fifth option, disclaiming all or part of the assets, may apply if youthink including the inherited assets could result in your estate exceeding thefederal estate tax exemption limit for married couples which is approximately$11.2 million for 2018. If this pertainsto you, then you’ll want to add disclaiming assets to the list and consult withan attorney.
One overarching rule to remember is that the tax rules differ when youare the deceased’s spouse. For rulespertaining to non-spouse inherited IRAs, read: InheritedIRA Rules That Non-Spouse Beneficiaries Need To Know.
If you inherit your spouse’s IRA, consider these tips before decidingbetween the four options:
Widows should carefully consider their options before making a decision about how to handle an IRA passed to them from their spouse.
Age matters
Surviving spouses are the only inheritors allowed to rollover assets intoan IRA in their own name. This may be agood option if you don’t need the money in the near future, or if you canafford to hold the assets in the IRA to take advantage of its tax-favoredstatus. If you don’t need the income orassets before age 59 ½, rolling them over into your own IRA will allow you todelay taking required minimum distributions (RMDs) until you reach age 70 ½. Keep in mind that if you need to access theseassets and you are under age 59 ½, you’ll pay a 10% penalty if they arewithdrawn from a Traditional IRA in your name. Having a long-range financial plan is the bestway to know whether you will need this money now or if you can likely keep itinvested until you turn 70 ½.
Choosing to rollover the IRA to an inherited IRA may be agood choice if you’re under age 59½ and need the income or assets now, becausewithdrawals are not subject to a 10% penalty.You can withdraw any amount as long as you meet the RMDs starting in theyear after the year of your spouse’s death. You can also choose to delay taking RMDs untilthe year your spouse would have turned age 70½. Since the penalty isn’t an issue in thisdecision, one main consideration is how withdrawals will impact your totalincome tax bill.
You can also invoke the 5-year rule that applies to rollovers toan inherited IRA. If your spouse wasyounger than age 70½ when he or she died, you can take up to 5 years towithdraw assets from an inherited IRA.However, the rule requires that all assets be withdrawn byDecember 31 of the fifth year after your spouse's death. Because of that provision, you’d want tochoose this option only if you’re willing to incur the income taxes associatedwith each withdrawal and the requirement to take everything out of the account withinfive years.
Your age matters if you don’t rollover the account but instead take the assetsout for spending. You will pay a 10%early withdrawal penalty if you are under age 59 ½. In addition, these funds become taxable to youas ordinary income. If you are youngerthan 59 ½ when you inherit the funds, we typically advise rolling over theassets into either your own or an inherited IRA unless you have no other sourceof income or means to support your costs of living.
RMD rules can be confusing for inheritors,especially if their spouse passed away at age 70½ or older. The confusion comes from the tax requirementthat the deceased must take their RMD for the year in which he or she passedaway. If they didn’t take it beforedeath, then the inheriting spouse must take the withdrawal before the end ofthe year of their spouse’s death.
Beware ofthe tax monster
As mentioned before, taking a full distributionfor an IRA could significantly reduce the amount of money you will have tospend because of the impact of taxes and potential penalties. What often gets missed in analyzing the optionof taking a partial or full withdrawal is the impact a distribution has on youroverall marginal tax bracket. Distributionsyou take from an inherited IRA will generally be taxed as ordinary income, nomatter your age. That increase in incomecould move you into a higher tax bracket, meaning you’ll pay more of thedistribution out to cover federal income taxes.
Depending on the size of the IRA distribution,there may be other income tax consequences such as higher capital gains taxrates, a reduction in deductions, and Alternative Minimum Taximplications. If you’re thinking about takinga full distribution, we recommend that you consult with a CPA to determine youroptions and the potential tax consequences.If possible, you may want to consider splitting your withdrawals over atleast two tax years as a way to potentially reduce your total taxes.
Consider allsources of income and assets
Another way to determine which of the four options suits your needs is toanalyze your overall financial picture.Compiling a comprehensive balance sheet and preparing a long rangefinancial plan is one of the best ways to understand all the resources you haveavailable for meeting your income and support needs for the remainder of yourlife. It’s only after this analysis thatyou can determine whether immediate use of the funds is necessary or whetheryou can take advantage of any tax-deferred growth by choosing one of the rolloveroptions. If you decide that liquidatingthe IRA and taking a distribution is your best choice, be sure to set asideenough cash to pay the taxes. If youdon’t reserve that cash up front, you could be hit with a big tax surprise andneed to scramble for cash to pay your tax bill the following April.
The fourth option, converting the assets to a Roth IRA, requires a moredetailed review of your income and assets and should only be considered withthe help of a CPA and/or a financial advisor.This analysis is important because you will be required to pay ordinaryincome tax on amounts you convert from an inherited IRA into a Roth IRA. This option usually makes sense only when youhave sufficient liquid assets to pay the conversion tax and if you also expectto be in a higher tax bracket in the future.
Ask for help
Even if you navigate thedecision-making without the help of a financial expert, you may want or need toask for advice as you complete the required paperwork to execute your decisionsince the forms for either a distribution or rollovers can be complicated. Even with the conviction that you’ve made theright decision, you’ll need to be sure the custodian or holder of the assets executesyour decision properly. If you decide torollover assets, make sure the assets transfer directly from your spouse’saccount to the new account. You don’twant to receive a check as that runs the risk of being considered a taxabledistribution.
For an inherited IRA, the accounttitling is important and should include the name of the deceased, your name,and specify that it’s a beneficiary IRA. Do not comingle an IRA inherited from yourspouse with other IRAs you’ve inherited because RMD and other rulesdiffer. And no matter which option youchoose for taking the assets, you’ll want to pay attention to the documents youreceive, including initial statements that record the transaction(s) and taxforms you will receive in the following calendar year.
Consideryour legacy
If you choose to rollover funds to either an inherited IRA or an IRA ofyour own, be sure to designate your beneficiary when you open the account. That may require you to consult with anestate planning attorney, especially if you’re considering beneficiaries whoare minors. Beneficiary designations areincluded in the initial account opening paperwork so carefully consider youroptions when completing those forms. Formore information, read: 7Common Mistakes to Avoid When Naming Your Beneficiaries.
Conclusion
Analyzing your options involves an understanding of complex tax laws plusconsideration of many dimensions of your wealth including your age, the age ofyour spouse, income, other assets, and spending needs, to name just a few. We highly recommend that you carefully weighyour options and ask for help from your financial advisor or CPA so that youmake the best decision for your situation.
