When a Child Inherits an IRA

By Mark Kennan

Many parents list their children as the beneficiaries on their retirement plan accounts, including IRAs. The Internal Revenue Service does not change the beneficiary rules when a child rather than an adult inherits an IRA. Knowing the rules for when a child inherits an IRA helps direct more of the inheritance to the child's bank account and less to the IRS.

Distribution Options

The default option for taking distributions from an inherited IRA is to distribute the entire balance by the close of the fifth year after the decedent's death. Under this option, distributions can be taken at any time before the end of the fifth year, so long as the entire IRA is distributed. However, children often benefit from choosing the second option, which allows them to take much smaller annual distributions over their lifetime. This allows more of the money to remain in the IRA for a longer period of time.

Calculating Annual Distributions

The annual distributions are calculated based on the account value as of December 31 of the previous year and the child's life expectancy in the year the decedent dies, using Table I in IRS Publication 590. For each year after the decedent's death, subtract one from the life expectancy. For example, if the child's life expectancy is 65.4 years in the year of the decedent's death, for the first year after divide the value by 64.4. In the second year, divide the value by 63.4, and so on.

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Income Tax Reporting

Depending on the size of the distribution the child takes, the child's income for the year may exceed the filing threshold, thereby requiring the child to file an income tax return. On the return, the distribution is taxable in the same manner that it would have been for the decedent. Typically, this means a traditional IRA is going to be fully taxable. However, if the decedent made nondeductible contributions, either because the decedent had too high an income and was covered by an employer plan or simply elected not to deduct them, that portion of the distribution is tax-free to the child. For example, if at the time the child takes the distribution 13 percent of the inherited IRA's value is from nondeductible contributions, 13 percent of the distribution is tax-free.

Remember the Decedent's Last RMD

If the decedent is required to be taking minimum required distributions, the decedent or the decedent's estate is still required to take one in the year of death. For example, if the decedent turns 70½ or older in the year of death, the decedent needs to take a required distribution. If the decedent dies on January 15, 2013, before taking the required distribution, the estate must take the 2013 required distribution. Failing to do so results in the 50 percent penalty on the amount that should have been distributed. The child who inherits the IRA must start taking required distributions the following year.

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IRA Beneficiary Rules

An individual retirement arrangement is a savings plan designated for retirement purposes. By designating it as retirement savings and giving up the freedom associated with typical savings accounts, individuals receive preferential tax treatment. The type of plan – whether traditional IRA or Roth IRA – will determine the timing of the tax preference. Traditional IRAs provide the account holder with a tax deduction in the year the contributions were made, while Roth IRAs do not provide an up-front deduction, but allow for tax-free distributions at retirement. Given the tax benefits, individuals may contribute to an IRA until they reach age 70 1/2.

401(k) Inheritance Laws

Many companies sponsor 401(k) plans to help their employees save for their retirement years. When a person dies with money remaining in the plan, the named beneficiaries receive those monies. However, the IRS has rules that specify when distributions from the plan must be taken and the tax consequences of those distributions.

Procedures for Disclaiming an IRA Inheritance

A beneficiary can disclaim an IRA inheritance if he does not want all or part of the IRA. A beneficiary may want to disclaim if he is already wealthy and the next eligible beneficiary could benefit more from the inheritance, or if he is facing personal bankruptcy and would likely lose the inheritance in any case. After a beneficiary disclaims his inheritance, he will be treated as never owning any of the inheritance, and the IRA will not be included in his estate. The proper procedure must be followed to ensure a disclaimer is valid.

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