Personal Finance

Money Matters: Daughter inheriting IRA annuity has options

Q. My daughter has an inherited IRA annuity and wants to cash it in. It was set up so she has to take a yearly distribution. If she withdraws the entire amount, she will be taxed about 40 percent because of her income and federal tax penalty for early withdrawal. Is there a way she can move this money to another investment fund that wouldn’t tax her as much if she withdrew it? Could she transfer or withdraw a partial amount so she is not taxed as much? She is a teacher so her normal federal income tax bracket is fairly low, less than 15 percent.

A. A non-spouse has several options when inheriting an IRA. Unless your daughter is desperate for cash, withdrawing the entire amount in one year and subjecting the distribution to federal and state income taxes is the least desirable option. If she is not desperate, I’d only suggest this option if the value of the IRA was insignificant.

Some parts of your question lead me to believe that you may not understand the options available to a non-spouse IRA beneficiary. An explanation of these options should be helpful. First a couple of things a non-spouse may not do with an inherited IRA. They may not treat the IRA as their own. A non-spouse can’t contribute to the IRA or make any rollovers into or out of the IRA. The IRA should be set up as a beneficiary IRA. Inherited IRAs will be titled as “beneficiary name” beneficiary IRA of “deceased name” IRA. If there are multiple beneficiaries, it makes the most sense for each beneficiary to set up their own IRA. If the IRA is not split into multiple accounts, the required minimum distribution (RMD) is based on the life expectancy of the oldest beneficiary. If the IRA is split into separate accounts for each beneficiary, the RMD will be based on the life expectancy of the individual owner.

RMDs must be made by December 31st of the year after the deceased IRA owner’s death unless the IRA owner died before reaching age 70 1/2. If the owner was younger than 70 1/2, the inherited IRA may be distributed under the five year rule. Distributions can be taken as you like without penalty (still subject to income tax) as long as all assets are distributed by December 31 of the fifth year following the original IRA owner’s death. If the deceased IRA owner was age 70 ½ or over, the assets are still titled as a beneficiary IRA but the assets can be distributed over the beneficiary’s life expectancy or the deceased’s life expectancy. This option is valuable if the deceased is younger than the beneficiary. If RMDs are not taken, a 50 percent penalty is owed.

If the deceased has not met their RMD during the year of their death, this amount must be taken out by the end of the year by the beneficiary.

You can always take a distribution larger than the RMD amount, you won’t owe a penalty, but as with your daughter, it may place you in a higher tax bracket. If your daughter doesn’t like the annuity she may have the option of transferring the beneficiary IRA to another type of investment. If you can’t dissuade your daughter from cashing out the entire IRA, spending some money for a consultation with a tax or financial professional would be wise; loosing 40 percent to taxes makes no sense to me. The professional can also advise her on her different investment options.