If you inherit an IRA, make a plan before doing a thing

Given that one-third of U.S. households own at least one type of individual retirement arrangement (IRA), odds are high that you might inherit one someday. And when that happens, you’ll need a plan of action, one that avoids common and what can be costly mistakes.

 So what’s the first order of business? Figure out what type of plan is being inherited — we’ll assume here it’s a traditional IRA  — and what type of beneficiary  you are. Then, do your research. “Don't take the funds out of the deceased's IRA until you know what you are going to do with it,” says Allen Gibson of Gibson Private Wealth Advisors.

If you the surviving spouse of an IRA owner:

Surviving spouse beneficiaries  have four options:

1. Roll the inherited IRA assets into their own IRA. This has plenty of advantages. One, the beneficiary can postpone required minimum distributions (RMDs) until age 70½, says Gibson. Plus,  beneficiaries can use their own life expectancy to calculate RMDs,   says Jeffrey Levine, an IRA consultant with Ed Slott and Co.

And best of all, it’s simple. “You don’t have to maintain an inherited IRA and your own IRA, they can be combined,” says Levine.

Disadvantages: The beneficiary will — with a few exceptions — have to pay a 10% penalty tax on pre-59½ distributions, says Levine. “Plus, RMDs could be accelerated if the deceased spouse was younger than surviving spouse.”

2. Transfer the  assets into a properly titled inherited IRA.  A couple advantages to this tactic: One, the spouse beneficiary won’t have to pay the 10% penalty tax when taking withdrawals from an inherited IRA prior to age 59½, says Joseph Brooks, president of Fairhaven Financial Advisory Corp. And two, you might be able to delay RMDs if the deceased spouse was younger.

Among the disadvantages: Complexity. The beneficiary will have to maintain  their own retirement accounts separate from their inherited IRA, says Levine.

Considerations: an example of a properly titled inherited IRA would be “John Smith, Deceased, Inherited IRA FBO Bill Smith, Beneficiary.” Also, be sure to establish the inherited IRA before Dec. 31 of the year following the death of the owner, says Brooks. “And, if you are going to put it in an inherited IRA you have to do a direct trustee-to-trustee transfer,” says Gibson.

3. Convert decedent's IRA to the survivor’s Roth IRA.  It’s an option, but don’t try this without first talking to an  expert. “Understanding the rules can make all the difference in avoiding surprises in the future,” Robert Bloink and William Byrnes, professors at the Texas A&M School of Law, wrote in a recent article on the subject.

The surviving spouse might choose this option if they expect to be in a higher tax bracket later in life, though they also have to think about the tax brackets of those who might inherit their Roth IRA, too.

4. Disclaim all or part of the assets.  Again, you wouldn’t want to do this without talking to a competent tax adviser and estate-planning attorney. That said, there are some of advantages: You might be able to have assets pass to younger beneficiaries, who get to use their life expectancies for RMDs, says Levine. Plus, this keeps assets out of the surviving spouse’s estate, he says. You’d likely choose this option if the  estate wasn’t set up properly, or if the surviving spouse doesn’t need the money.

There are some negatives: One, it’s irrevocable, says Levine. Plus there’s no control over where the money goes. “It just falls to the next beneficiary in line.”

If you are a non-spouse beneficiary?

You can’t roll over inherited IRA assets into an IRA in your name, but you do have a couple options.

1. Transfer assets into an inherited IRA.  You will have to take RMDs from the inherited IRA, but the good news is that they will be based on your age and life expectancy rather than that of the original account owner. That, according to Levine, minimizes the taxes owed.

Experts suggest that there aren’t negatives associated with this tactic. “If you want to take the money sooner than the stretch, you can always do so,” says Levine.

2. Disclaim all or part of the assets. Levine says the pros and cons to this strategy are largely the same as they are for a spouse beneficiary.

Three points to remember:

1. Funds  must be transferred to an inherited IRA by Dec. 31 following the year of death  for non-spouse beneficiaries to “stretch” the plan assets over their life expectancies.

2. Custodians/plan administrators are not required to offer to calculate RMDs for inherited IRAs: Beneficiaries are often on their own.

3. Non-spouse beneficiaries must generally take RMDs from their inherited IRAs yearly starting the year after death of the owner.

Source: Joseph Brooks, president of Fairhaven Financial Advisory Corp. in East Lansing, Mich.

10 common inherited IRA mistakes

1. Not establishing the inherited IRA properly; an example of proper titling would be “John Smith, Deceased, Inherited IRA FBO Bill Smith, Beneficiary”

2. Using the wrong Life Expectancy Tables; must use the Single Life Table and not the Uniform Table or Joint Life Expectancy Table

3. Using the wrong Life Expectancy factor; must use the life expectancy factor of the beneficiary in the current year

4. Failure to take Required Minimum Distribution (RMD) after death of owner and in future years – this mistake is subject to a 50% penalty

5. Using the wrong IRA balance for RMD calculation. Must use the value of the account as of Dec. 31 of the prior year to calculate the RMD. Under-withdrawal is subject to a 50% penalty.

6. Failure to name beneficiaries may result in acceleration of distribution for the inherited IRA beneficiary.

7. Failure to do a trustee-to-trustee transfer in the establishment of an Inherited IRA; the 60-day rollover rule does not apply here.

8. Adding other non-inherited IRA funds to an inherited IRA.

9. Failure to confirm that RMD is taken out of account by Dec. 31 each year.

10. Not establishing the inherited IRA before Dec. 31 of the year following the death of the owner.

Source: Joseph Brooks, president of Fairhaven Financial Advisory Corp. in East Lansing, Mich.

Robert Powell is editor of Retirement Weekly, contributes regularly to USA TODAY, The Wall Street Journal and MarketWatch. Got questions about money? Email Bob at rpowell@allthingsretirement.com.