How To Divide an Inherited IRA Without Triggering Income Taxes: Don't Take a Check!

Q: My mother left an IRA on which she named her four children as beneficiaries, each of us to get 25% of the account. I have given the bank a copy of the death certificate.  I’ve talked to a lawyer, and he said that if my mother designated us as beneficiaries, and the bank has a death certificate, it can issue checks to the four of us.  My siblings are waiting on me for the go ahead to do this. But I guess I want to know what will happen before I do it. --CF, via email

A: That's a very wise policy! Here’s what will happen: If you take your inherited IRA in the form of checks from the bank, you and your siblings will owe income taxes on this money. Since each of your shares will be added to your 2010 taxable income, you might even be bumped into a higher tax bracket.

The lawyer you consulted may not know how IRAs are taxed. Unfortunately, the bank may not know either. Most banks know a lot more about how money goes into IRAs than about how it comes out.

To divide this account without triggering taxes, you and your three siblings should ask the bank to divide the IRA into four new IRAs … but not into new IRAs that list you as the owners! Your mother's name must remain on each of the new accounts as the deceased owner, with the name of each child on the account as its beneficiary. 

For example, if your Mom’s name was Joan Smith, each of the four new IRAs should be titled “Joan Smith IRA (deceased November 20, 2009) for the benefit of [insert name of one child].”

If necessary, insist on seeing a bank manager to make sure your mother’s name stays on the IRAs, says Barry C. Picker, a tax accountant and IRA expert.  Only a surviving spouse can transfer an inherited IRA into his or her own name. If any other beneficiary does that, the account stops being an IRA and is immediately taxable.  

If this is done right, each of you will have an inherited IRA that lists him or her as its sole beneficiary. At that point, if you wish, you can have your inherited IRA moved from your mother’s bank into your own bank – or to any other financial firm -- in a trustee to trustee transfer. (You open a new IRA at your own bank -- again making sure it's titled the right way, with your mother's name on it -- and the transfer is done by wire between the banks.)

As beneficiaries you must start taking minimum annual distributions from the account by December 31 of the year following your mother’s death; but the balance will continue to grow untaxed.

As the sole beneficiary on the account, you can take minimum distributions based on your own life expectancy, says Picker. This is one of the advantages of dividing the account correctly. If you keep an inherited IRA with four beneficiaries listed on it, the required minimum distributions must be based on the life expectancy of the oldest beneficiary.

Of course you can take more than the minimum distribution if you need it. But if you don't, why pay taxes on this money sooner than you have to?

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved