How to avoid big mistakes with inherited IRAs

When an individual retirement account is inherited, especially by a non-spouse, care must be taken to handle it properly.

Inherited IRAs can be a great supplement to an heir’s own retirement plan, but if IRS rules aren’t followed closely, beneficiaries could encounter unnecessary income taxes and penalties.

Here’s how to avoid the biggest mistakes made with inherited IRAs:

1. Update your IRA beneficiaries every few years. Incorrectly named beneficiaries (or not having one named at all) makes it highly unlikely that intended beneficiaries receive what the IRA owner intended, much less being able to stretch distributions of the balance out over their lifetimes. Designated beneficiaries on an IRA account supersede instructions in a will.

2. Don’t commingle an inherited IRA with other IRA assets. If you inherit multiple IRAs from the same person, you can combine them into one inherited IRA. However, you cannot combine assets inherited from different individuals, or into your own IRA. And you cannot combine different types of inherited IRAs (Roth IRA, traditional IRA) even if they were inherited from the same person.

3. Distributions from non-spouse inherited IRAs are not subject to the 10 percent penalty. That’s regardless of the beneficiary’s age when the distribution occurs. These distributions must be coded by the IRA custodian as “death distributions” so the 10 percent penalty doesn’t apply. They still must pay income taxes on each distribution, however.

4. Mind the distribution options for inherited IRAs. There are two sets of distribution options for non-spouse inherited IRAs. First, if the IRA owner dies before taking required minimum distributions (RMDs), the beneficiary can distribute the IRA out within five years of the owner’s death, or can stretch it out over their single life expectancy, thus lowering taxes. Second, if the IRA owner dies on or after beginning RMDs, the beneficiary can distribute the account out over the longer of the remaining life expectancy of the decedent or the life expectancy of the beneficiary.

5. Stretch inherited IRAs out over a beneficiary’s lifetime. Once the inherited IRA is transferred to a properly titled account for the non-spouse beneficiary, it generally will lower income taxes if they stretch the payout of the account out over their lifetime using the single life expectancy payout option. If the original IRA owner didn’t take a distribution in the year they died and should have, the beneficiary must take it and pay tax on it.

6. No 60-day rollover option. IRA owners can take a distribution from their IRAs without triggering income taxes and penalties as long as they deposit the money back into the same account within 60 days. This strategy is often used to fund short-term cash needs, such as closing on a new house before selling the old one. Unfortunately, this strategy can’t be used with inherited IRAs. If money is withdrawn, it’s taxed.

7. Consult a qualified financial professional. When it comes to inherited IRAs, don’t rely on the information you’re getting from the IRA custodian. Be sure to get help from a qualified financial professional who has your best interests in mind.

This story was originally published September 19, 2016 at 10:37 AM with the headline "How to avoid big mistakes with inherited IRAs."