Ask Lynn - This Week’s Column

Baby boomers aren’t optimistic about their chances of inheriting much money from mom and dad. Most Boomers, according to the AARP, don’t expect anything. And those who have already had free money dumped into their laps have pocketed about $48,000. You could blow that amount by making eye contact with a salesman on a car lot.

Most of us aren’t going to inherit a Trump-sized windfall, but that doesn’t mean that what we inherit can’t be financially invaluable. If you’re familiar with the Biblical story of the loaves and fishes, you can appreciate the possibility of turning something that could rattle around inside a shoe box into something that’s exponentially monstrous. You can pull off your own financial miracle if you are ever lucky enough to inherit an Individual Retirement Account.

Here’s the beauty of an inherited IRA: The money nestled inside one of these cocoons can potentially keep growing for decades after the original owner has died. All the IRS requests is that a beneficiary make a modest withdrawal each year. When the money is left largely undisturbed and sheltered from taxes, it’s amazing how fast those dollar bills can replicate.

To appreciate the beauty of an inherited IRA, you need to understand its potential. Let’s suppose that a 45-year-old woman inherits a $50,000 IRA from her mom. Rather than cashing in the IRA and paying income tax, she chooses to stretch her required withdrawals over the next 38.8 years, which is what the IRS says is her life expectancy. If the IRA grows at an average annual rate of 8%, she’d pull out $303,113 before the IRA is depleted.

The value of an inherited IRA is even more stunning when someone receives a jumbo IRA. If the same hypothetical daughter inherited a $500,000 IRA, she’d withdraw a whopping $3,031,136 before it was finally emptied. A grandchild who inherited that IRA and took withdrawals over her life expectancy, would make the $3 million look like the change you’d pocket after ordering a Big Mac.

Unfortunately, many Americans, when they inherit an IRA, don’t appreciate what they’ve got. They ransack the account, pay the taxes and return to bitching about not having enough money.

Whether you expect to inherit an IRA or give one away, here’s some advise to ponder:

Convert to a Roth. Last week I praised the Roth IRA as the superior IRA choice. When you pull money from a Roth during retirement, you won’t owe any taxes. And if you’d rather leave the cash alone, you can. Not so with a deductible IRA. With one of these, you must pay taxes on all withdrawals and you’ve got to start tapping into the account not long after reaching 70 1/2.

Not surprisingly then, a Roth is an infinitely better parting gift for your loved ones. It’s true that a Roth beneficiary will have to make yearly withdrawals–the IRS won’t wait forever for this money to be recycled. But your kids, grand kids, or whoever inherits the cash won’t pay any taxes on the withdrawals. In contrast, anybody who inherits a traditional IRA, will owe income taxes.

If you don’t need your IRA cash and the money is just parked inside one until the kids inherit it, you may want to consider converting it into a Roth. Converting a deductible IRA into a Roth requires that you pay income taxes on whatever amount you decide to convert. You can’t convert to a Roth if your gross adjusted income exceeds $100,000 during the year of the conversion. The same ceiling applies to singles and married couples.

Name the right beneficiaries. Make sure you leave your IRA to the right person! This seems obvious, but people blow it all the time. When you established an IRA at a financial institution, you filled out an IRA beneficiary form. Remember? Actually, most people forget about the form, but it’s important because this piece of paper dictates who receives the cash inside this account when you die. Failing to update the beneficiary form can be disastrous. If you never remove a former spouse from your IRA, for example, it’s the ex who will collect the money. The same thing can happen if you established an IRA years before getting married. If you named your parents or siblings and never changed the designation, your wife or husband won’t get squat. Don’t expect your will to bail you out of this whopper of a mistake. It can’t and won’t.

Roll cash into an IRA. When leaving your job, pack up your 401(k) when you’re emptying out your desk. If the cash is sitting in an IRA, children and grandchildren, who inherit this money, as mentioned earlier, can stretch their withdrawals over their lifetimes. If the money remains in a 401(k), that could be the end of the party. You may have to cash in the account far sooner than you’d like. A widower or widow, however, can transfer 401(k) money into his or her own IRA.

Don’t fumble an IRA hand off. Trying to discern the logic in great swaths of the IRS Code can drive a person into therapy. And here’s one of the code’s great head scratchers: If you inherit an IRA, you must leave the giver’s name on the account. If you substitute your name, the IRS can consider the IRA cashed out and you’d owe applicable taxes on the whole splattered mess. There is one significant exception to this IRA booby trap: If you inherit your spouse’s IRA, you can roll it into your own IRA.

When inheriting an IRA from someone other than a spouse, simply add your name and Social Security number to the account. Be careful if you wish to move mom or dad’s old IRA to the place where you keep your investments. Your parent’s financial institution may suggest cutting you a check, but if you cash the check and then move the money, the IRS will conclude the IRA has been disbanded.

Read more. Hard to believe that someone could write an entire book about IRAs–or would want to. But Ed Slott, a CPA in Rockville Centre, NY, who undoubtedly knows more about IRAs than anybody else I’ve ever interviewed, has done it more than once. You can learn a lot about inheriting IRAs by reading his books, including The Retirement Savings Time Bomb and Parlay Your IRA into a Family Fortune Grab the toothpicks and start reading.

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This entry was posted on Saturday, July 21st, 2007 at 7:10 pm and is filed under IRAs. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.