Q: I think people who inherit IRAs aren’t warned how carefully they must handle the accounts to avoid taxes. My brother-in-law recently inherited an IRA from his father. The funds were distributed directly to him in a check, which he subsequently deposited at another bank, into an `Inherited IRA' for himself as the beneficiary. When he filed his taxes, he reported only the distribution he had to take from that IRA, based on his life expectancy. But the Internal Revenue Service said the entire IRA was taxable because he had accepted a check. They assessed a tax penalty in addition to interest on late payment of the tax. Am I right that a `trustee to trustee' transfer is required for inherited IRAs? -- DB via email
A: You're right. If you take a check for inherited IRA proceeds, you've actually accepted a taxable distribution. Your brother-in-law was badly served by the original IRA custodian, and by the bank that accepted a check to open an inherited IRA.
Even when you're not dealing with an inherited IRA, a
trustee-to-trustee transfer is always the safest way to move money from one IRA
to another: The old custodian transfers the money to the new custodian. You
never touch it, so you can't be taxed on it.
But with an inherited IRA, you must do a trustee-to-trustee transfer to avoid taxes.
The bank that issued the check to your brother-in-law should have told him that it would all be taxable -- and the second bank should never have accepted it, says Ed Slott, a Rockville Centre CPA and author of `Parlay Your IRA into a Family Fortune'.
The IRS penalty must have been charged for his failure to report the entire distribution, adds Slott. IRA beneficiaries never owe an early withdrawal penalty, regardless of their age.
Unfortunately, this kind of mistake is not uncommon.
Banks, brokers, and mutual fund companies are experts at accepting IRA contributions, but they're much less familiar with the complex tax rules that govern IRA distributions.
In your brother-in-law's case, the mistake can't be rectified. Only a surviving spouse gets a chance to escape taxation after accepting a check for the proceeds of an inherited IRA: A widow or a widower has a 60-day window in which to roll a distribution from an inherited IRA into his or her own IRA.
But a non-spouse doesn't have the 60-day window because he can't roll an inherited IRA into an IRA in his own name. (As I’ve explained in other columns, the proper designation for an IRA that Joe Smith inherits from his father Harvey Smith is `Harvey Smith IRA (deceased) for the benefit of Joe Smith.')
"If the original IRA custodian insists on giving the beneficiary a check for the IRA proceeds, the check should be made out to the new IRA custodian," says Slott. "Instead of being made out to Joe Smith, for example, the check should be made out to the XYZ Bank Inherited IRA for the benefit of Joe Smith. That way, Joe can't cash it; it must be deposited. That qualifies as a trustee-to-trustee transfer."
Another pitfall for IRA beneficiaries is that some IRA custodial agreements don't allow an inherited IRA to be transferred a new custodian, he adds. Such transfers are perfectly legal -- but financial institutions aren't required to allow them.
"An IRA owner can always transfer funds to a new custodian," says Slott, "but an IRA beneficiary can only do a transfer if the custodial agreement allows it."
IRA owners, take note: Check the fine print in your
custodial agreement! If it doesn't give your heirs a free hand with their
inheritance, you should move your money to another custodian -- one that won't
hold your money hostage after you're gone.
Follow-up questions about inherited IRAs? If you'd like to know more, or think there's an issue I haven't addressed here, email me at Lynn@LynnBrennersFamilyFinance.com.