Lynn Brenner's Family Finance

Can I Move an Inherited IRA to a Different Investment Provider Without Being Hit With Taxes and Penalties?

Q: My wife recently inherited her father's IRA. It's earning a horrible interest rate. She wants to move it to a different investment for a better return, but avoid severe penalties. What options does she have? -- GS via email


A: Your wife should be able to move her inherited IRA without incurring any taxes or tax penalties, provided she does it correctly. The only potential cost might be a fee levied by the current custodian. For example, if the IRA is in a CD that hasn't yet matured, the bank will charge an early withdrawal penalty.

What your wife must not do is take a check for the account balance and deposit it in a new IRA elsewhere. If she does that, the money loses its tax-deferred status. She'll owe income taxes on the entire amount.

Wait a minute, some readers are thinking, can't you take money from an IRA without a tax penalty as long as you redeposit it in an IRA within 60 days?

Yes -- but only if you're the IRA's owner. An IRA beneficiary doesn't have that option. (As the original IRA owner's daughter, your wife can't become the IRA's new owner. Only a surviving spouse has the option of rolling an inherited IRA into a new IRA in his or her own name.)

An inherited IRA must be moved in a trustee-to-trustee transfer. The money should go directly from one inherited IRA into another inherited IRA that is titled exactly the same way, says Natalie B. Choate, a Boston, Mass attorney who specializes in estate planning and retirement benefits.

An inherited IRA must be titled in the original owner's name, and must include the beneficiary's name. For example: "John Doe (deceased 7/15/07) for the benefit of Jane Doe Smith."

Your wife can easily get an application to open a new inherited IRA at any bank, mutual fund, insurance company, or brokerage firm by calling their toll-free numbers or visiting their websites. (My own recommendation would be to open the new account at a large, low-cost mutual fund company like Vanguard Group, T.Rowe Price, or Fidelity Investments. The reason: It will give her inexpensive access to a virtually unlimited choice of investments.)

In the application, she should state that she's opening the new inherited IRA with money to be transferred from the old inherited IRA.

The new custodian -- let's call it XYZ Mutual Fund Company -- will then ask the current custodian to transfer the money into the new inherited IRA.

If the current custodian has any special requirements before releasing the money -- like having your wife's signature on the paperwork notarized or guaranteed, for example -- the XYZ Mutual Fund Company will get back to her and tell her what she needs to do to complete the transfer.

The only thing that could prevent the above scenario is a clause in your late father-in-law's custodial agreement prohibiting transfer of inherited IRAs.

This kind of prohibition is outrageous -- and relatively rare -- but unfortunately it isn't illegal. An IRA owner can always move his or her account at any time -- but an IRA beneficiary is governed by the custodial agreement. If this particular custodian doesn't let beneficiaries transfer inherited IRAs, your wife is stuck.

IRA owners, take note! Make sure your current custodial agreement lets your beneficiaries transfer their money elsewhere if they wish. If not, move your IRA to another custodian. Why do business with an institution that has decided to treat your heirs like prisoners?

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Must I Start Tapping All My IRAs After I Turn 70 and a Half, or Only My Deductible IRAs?

Q: I must start taking required minimum distributions (RMDs) from my IRA next year. I have some IRAs to which I made tax-deductible contributions, and others to which I made non-deductible contributions. When calculating my required minimum distribution, do I include the value of all my IRAs, or only the value of the before-tax IRAs -- i.e., the ones to which I made tax-deductible contributions? -- JM via email

A: You were smart to keep your deductible and non-deductible contributions in different IRAs. It can be a real headache to take distributions from an IRA that contains both!

Your 2010 required distribution is going to be based on the total balance in all your traditional IRAs on December 31 2009.

For purposes of this calculation, it doesn't matter whether or not you got a tax deduction for the IRA contributions. To the Internal Revenue Service, your IRA is just one pool of money, no matter how many accounts you have or how many contributions were deductible and how many weren't.

(Please note that we're talking about traditional IRAs. Don't include Roth IRAs in this calculation! You never have to take a distribution from your Roth IRA.)

As long as you take the correct dollar amount, you can take your required minimum distribution from any one of your IRAs or from several IRAs. But in your case, the income taxes you owe on that distribution will depend on which IRAs you tap for the required amount.

When you take money from a IRA that was funded with non-deductible contributions, only the earnings are taxable. Your original contributions are tax-free because you paid taxes on them before putting them into the IRA -- and each withdrawal is going to include some tax-free return of a contribution. "Making non-deductible IRA contributions is like putting cream in a cup of coffee. You can't take it out separately," says Ed Slott, a Rockville Centre NY tax accountant. "There's going to be a little cream in every sip you take."

To determine what percentage of each withdrawal is tax-free, you have to add up all your non-deductible contributions to the account and calculate what proportion of the total IRA balance they represent. "Let's say you make $2,000 of non-deductible contributions and the IRA is now worth $10,000," says Slott. "That means 80% of the account is tax-deferred earnings and 20% is after-tax contributions. When you take withdrawals, 80% of each withdrawal will be taxable, and 20% will be tax-free."

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Taxes on IRA Withdrawals: Which State's Tax Laws Apply When I Tap My Account?

Q:  Let's say I worked and contributed to my retirement account in a state that gives seniors a small tax exemption on their distributions from retirement accounts. Then when I retire, I move to a state that offers retirees a much more generous tax exemption for these distributions. Which state's tax exemption applies to me -- the one where I earned my pension, or the one where I now reside? -- AP, via e-mail


A: The laws of the state you live in are the ones that apply to you. Isn't that one of the reasons you moved to that taxpayer-friendly state in the first place?

Money you take out of tax-deferred retirement accounts is always subject to federal income tax; but some states let you exclude part of your withdrawal from your taxable income.

In my own home state of New York, for example, people who are over age 59 and a half pay no state income tax on the first $20,000 of their annual pension income. You get that $20,000 exemption no matter where you earned your pension or contributed to your IRA. For the purposes of this particular law, 'pension income' means money that comes out of your employer-sponsored retirement accounts, such as an IRA, 401(k), or 403(b) plan, and from tax-deferred annuities. It doesn't include Social Security, which has its own exemption from both state and federal income tax.

IRA beneficiaries who live in New York state get the same tax break on inherited accounts, regardless of their own age, provided the retirement accounts' original owner was at least 59 and a half years old. But this state tax exemption applies per decedent, not per beneficiary. In other words, three beneficiaries of one decedent can only inherit one $20,000 annual exemption.

For more information about which states are the friendliest when it comes to income taxes, check out this excellent article from the Washington Post.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Why Does My Son Want Me to Consult an Elder Lawyer? I Already Have a Will.

Q: My husband recently died. I want to be certain that my three children will inherit my house, which my husband built himself. My will leaves them everything I own. One of my sons recommends that I see a lawyer specializing in elder law. I am 78 years old and in good health. My monthly income from my pension and Social Security is about $1,800. A one hour elder law consultation will cost me $425, and I'm required to divulge my bank accounts, fixed annuity, IRA, and whatever other assets I have. But friends have told me elder lawyers would be adding charges that could go into the thousands. Won't my will suffice? Must I get involved with elder law? -- VT via email

A: The consultation won't commit you to paying anything except the $425 consultation fee.  The lawyer will tell you what additional services would cost. It's up to you whether or not you want to proceed.

Anything you tell him is confidential, privileged information. You don't have to take your kids along to this meeting; but if you do, you can ask them to leave the room before discussing your finances.  No experienced elder lawyer will expect you to divulge your assets in front of your children!

Is your will enough? Maybe, maybe not. Here's the potential flaw in your current estate plan:

Your will leaves the house to your children. But your son may be concerned that if you ever need nursing home care, the house might have to be sold to pay for that care. He probably hopes that an elder lawyer -- an attorney who specializes in estate planning, wills, trusts, and arrangements for long-term care -- can suggest a way to make sure that, if necessary, Medicaid will pay for your care without requiring the sale of the house.

Or he may hope the lawyer will assure him that you have sufficient savings to cover the cost of your care without having to sell the house.

There's nothing to panic about. You're in good health, and you may never need nursing home care. And if you ever do, you might decide that you prefer to sell the house to pay for your care rather than depend on Medicaid.

But all you need to decide at the moment is whether it's worth $425 to learn if there's a way to be certain your kids inherit the house your husband built no matter what happens. Whether or not you act on what you learn is another matter. And that, too, is entirely your decision.

Please send your questions to [email protected].  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved