Inherited IRA Snags

Under current rules, you can defer withdrawals from an inherited IRA for up to five years. Alternatively, you can take Required Minimum Distributions (RMDs), based on your life expectancy tables provided by the Internal Revenue Service.  By stretching withdrawals from an inherited IRA across the heirs' own life expectancies, assets could potentially increase in value, tax-deferred, for decades.

However, knowing the basics on inherited IRAs is just as important as knowing the snags that can trip you up. Mishandled paperwork, even when mishandled by financial and legal advisers, can result in the IRA being disqualified.  The following are some common snags to avoid with inherited IRA’s.

One of the most common problems involves how inherited IRA’s intersect with trusts. Many people who set up living trusts, often marketed as a way to avoid probate, name the trust as the IRA beneficiary. But a trust isn't a person, and has no life expectancy, so it can't take advantage of the opportunity to stretch withdrawals across decades.

When you inherit an IRA, you should retitle the account so it reads like this: "John Doe, Deceased (date of death) IRA F/B/O (for benefit of) Mark Smith, Beneficiary."

If the benefactor's estate were large enough to be subject to federal estate tax, and a federal estate tax were paid, then the IRA beneficiary can get a tax deduction for the estate tax paid on the IRA's value.

Many heirs forget they can disclaim an inherited IRA and pass it along to their children, possibly creating tax-deferred growth for decades.