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4 Steps Military Officers Should Take When Inherting an IRA

Retirement Funding Taxes Estate Planning

As you near the end of your military career or perhaps after your military retirement, it is possible that you will inherit an individual retirement account from your parents, an aunt or even a friend. However, it's important that the below steps and the IRS rules they describe are followed to the letter or the small errors one makes could prove to be expensive. There are several options on how you can handle the account, but it is dependent on some factors such as your relationship with the original account holder, the age of the original account holder, when they passed away and the type of account you inherited. Here are four crucial steps you should follow to avoid the expensive mistakes.

Step 1: Title the New IRA

I know military life can be busy, especially when dealing with a loss, but you must start the process. The first step after you inherit an IRA is to correctly set up an inherited IRA. If you skip this step, you will not be in a position to properly stretch the distributions. An inherited IRA should have the name of the deceased original owner, and it should also indicate that the IRA was inherited. However, the case is different when the deceased was a spouse because the surviving spouse can roll over the amount in the inherited IRA or into their own account. If you inherit an IRA from your spouse and you are younger than 59 1/2,  it is critical you understand the options available with an inherited  IRA versus rolling the funds into your IRA. When setting up the inherited IRA, you should name your beneficiaries. If you pass on without emptying the inherited IRA your beneficiaries will continue taking the distributions but according to your life expectancy. If you work with a financial advisor he should be able to help you with all this.

Step 2: Calculating the Right Distribution Amount

The prior year-end account value and the life expectancy are needed to calculate the distribution amount. For this calculation, the value of the account from the last year is used. For example, to calculate the distributions for the year 2018, the account value on 31st December 2017 is used. Life expectancy is also important, and the heir, if not a spouse, can use the Single Life Expectancy Table. However, it can be done only once, and every year after that the heir must deduct one from the previous year’s factor.  Fortunately, in most cases, the custodian of the inherited IRA will calculate this for you.

Step 3: Determine If the IRA Has an After-Tax Basis

Most beneficiaries are either not aware, or they do not bother to find out if the IRA they just inherited has an after-tax basis or not. This would be the case if the original IRA owner made non-deductible contributions to a Traditional IRA. If this is the case, tax is not due on the after-tax basis when withdrawn. Such a single mistake can prove quite expensive in the future. If you have inherited an IRA and you find out that it has an after-tax contribution, you should make the effort of filling in and filing the IRS Form 8606. Filing this form will allow you document the non-deductible portion of the required minimum distribution. You can ask the executor if they know if it has an after-tax contribution but they might not know. The executor may be able to check the tax returns of the deceased to find out if he or she filled the form in previous years. To be sure, you should do some research on prior year tax returns, if you have access to them.

Step 4: Make a Plan for the Taxation of Distributions

Taxation of distribution is different for Roth IRAs and other IRAs. With Roth IRAs, in most cases, the distributions are tax-free if the beneficiary is taking the minimum distributions. However, for other IRAs, the distributions are fully taxable unless the original IRA owner had a tax basis on his or her IRA. You can refer to step three above to find out if the IRA had a tax basis. If the distribution is taxable, you should add the taxable portion of the distribution to the tax projection for the year to find out the amount of tax to withhold.

To avoid making expensive mistakes, you should hire a knowledgeable adviser as soon as you get a notification that you have inherited an IRA. A single mistake could mean that you lose your ability to stretch the payments. A mistake could also get you stuck with a large tax bill on the amount you inherit.


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