An Inherited IRA Must Be Moved Very, Very Carefully

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 [email protected].

 

Comments

[T J]

I am trying to help my father get everything transferred into my name before his death in order to keep his stepkids from taking all of the money out of his estate.

His wife did not leave a will to his knowledge and the house that he is now living in is not in his name; the house title is in his wife's name who passed away. There is a lien against the house because of a loan from one of her kids and she did not pay it off prior to her death. The kid said he would allow my dad to live there as long as he is alive.

He is afraid the kids from her first marriage will try to take the house and if he does not pay the amount of the lien he does not want it coming out of his assets that are in his name in the event of his death.

So we are trying to get everything put into my name before my father's death; that way they can not go after his assets in order to pay HER debt. How do we get his 401K/IRA ,savings and money market accounts into my name so everything is in my name and not his upon his death?

Since he inherited the house because he was the surviving spouse in the marriage, does he have legal rights in the event that the kids demand him out of the house and put it up for sale? Because he is the one that made all of the house payments when the house was refinanced. She had a lot of credit card and various bills with high interest so they refinanced the house. He was told that once that loan was paid off the title would be changed to show both of their names. But before that happened the loan was sold twice before returning back to the original loan company.

[Lynn Brenner]

Lynn replies:

If your step-mother left no will, her kids are in much greater danger of being screwed than you or your father.

It's more than likely that, as you say, your father automatically inherited this house as her surviving spouse. If so, he owns it regardless of whose name is still on the deed. If he inherited the house, he presumably also has inherited any liens against it.

But if the lien is against the house, it will be exercised against the value of the house. It cannot be exercised against against your father's IRA or 401(k). So you can tell him to calm down.

As for you, there is no way that you can transfer any of your father's accounts into your name. He is the only person who can give away his assets. But even he doesn't have the legal power to transfer his 401(k) accounts or his IRAs into your name. Nobody does. And a what good thing that is!