W hen a loved one dies, you may be the beneficiary of his/her IRA. That account can help you meet current needs, build long-term wealth or both.

Traps: You may overpay the tax on future distributions. You may owe tax that could have been avoided. Or you might lose the opportunity for extended tax deferral. If you know the rules, you can avoid costly mistakes...

ROTH OR TRADITIONAL?

You may inherit either a traditional IRA or a Roth IRA.

Traditional IRA. Most IRA owners have traditional IRAs. If you are the beneficiary, you probably will owe ordinary income taxes on all withdrawals that you make from the account. But if the original IRA owner made non- deductible contributions to the account, some part of each of your withdrawals will be tax free.

Example: If you are the beneficiary of a $100,000 traditional IRA that contains $6,000 of nondeductible contributions, 6% of the money that you withdraw won’t be subject to income tax.

What to do: Ask the decedent’s tax preparer if IRS Form 8606, Nondeductible IRAs, was filed by the IRA owner. That will show the total of nondeductible contributions.

Roth IRA. These accounts are fully funded by nondeductible contributions. Therefore, all withdrawals may be exempt from income tax.

Trap: Contributions to a Roth IRA always can be withdrawn tax free. However, withdrawn earnings are taxable until the first day of the fifth taxable year after the year the decedent’s first Roth IRA was established.

Example: John Jones first established a Roth IRA in 2008. He died in 2009 after contributing a total of $10,000. Ann Smith, his beneficiary, may withdraw up to $10,000 (his contribution) without owing income tax. Withdrawals in excess of $10,000 will be taxed if they are taken before January 1, 2013. On or after that date, Ann can take as much as she wants from that account tax free.

withdrawal strategies

When an IRA owner dies and names you as the beneficiary, you can withdraw any or all of the account. If you need money for current living expenses, withdrawals from an IRA can fill the gap.

If you don’t need money from an IRA, you may be tempted to keep the IRA intact for potential tax-free growth. However, except during 2009, nonspouse IRA beneficiaries (traditional and Roth) of any age must take annual required minimum distributions starting in the year after the year of the IRA owner’s death. The amount of a person’s minimum distribution can be determined by referring to IRS Publication 590, Individual Retirement Arrangements. (The requirement to take a minimum distribution has been suspended for 2009 only.)

Powerful penalty: Starting in 2010, failure to take required minimum distributions will generate a tax equal to 50% of the amount that should have been withdrawn but wasn’t.

SURVIVing spouses

The required minimum distribution rules are different for spouses than for other IRA beneficiaries. A surviving spouse who is an IRA beneficiary can directly transfer or roll over the decedent’s IRA to his/her own IRA, in his name. (A direct transfer is usually much quicker.) He can name new beneficiaries for estate-planning purposes. Going forward, the surviving spouse will face the same minimum distribution rules as any IRA owner...

No distributions are required until April 1 of the year after the IRA owner reaches age 70½.

After age 70½, annual required minimum distributions are based on the IRS’s Uniform Lifetime Table (in Publication 590 and at www.irahelp.com under "IRA Resources").

Example: At age 76, the table shows a 22-year life expectancy, so 1/22 of the account must be withdrawn. If you have $100,000 in an IRA, you must withdraw at least $4,545 to avoid a 50% penalty. The less you withdraw, the more that stays in the account and the more wealth that may accumulate free of income tax.

Trap: A surviving spouse who rolls his deceased spouse’s IRA to his own name probably will owe a 10% penalty on any withdrawals before age 59½. Therefore, younger surviving spouses who’ll need the cash flow may decide against a rollover.

If the account isn’t rolled over to a new IRA, a surviving spouse can leave the IRA in the decedent’s name.

Result: The surviving spouse can then take distributions before turning 59½ without owing a 10% penalty.

Once he is past age 59½ and the 10% penalty no longer applies, the surviving spouse can change his mind and roll over his deceased spouse’s IRA to his own name. He would then get to name his own beneficiary and would be able to postpone distributions until age 70½.

other HEIRs

IRA beneficiaries other than a surviving spouse can’t roll over the accounts to their own names. Instead, the accounts can be retitled as inherited IRAs.

Example: If Bonnie Adams inherits an IRA from her father Alan Adams, the money might be retitled as an IRA in the name of Alan Adams, deceased IRA, for the benefit of Bonnie Adams (or f/b/o Bonnie Adams). Then, instead of accelerated distributions, Bonnie can stretch required minimum distributions over her single life expectancy.

Trap: Don’t transfer an inherited IRA into an IRA in your own name. Say that Bonnie Adams transfers her father’s IRA into an IRA in her name alone. The IRS would treat that as a distribution. Bonnie would owe income tax on the transfer, she would owe a fine of 6% per year until the amount of the transfer is withdrawn and she would lose the chance for extended tax deferral.

MULTIPLE beneficiaries

Special care must be taken if an inherited IRA has more than one beneficiary.

Suppose that Alan Adams died in 2009. He named his two children (Bonnie and Carl) as equal IRA beneficiaries. Bonnie is 55 in 2010 and Carl is 65.

Strategy: By December 31, 2010, the two beneficiaries can establish separate accounts.

To do so, they would tell the IRA custodian to directly transfer 50% of the money into an IRA in the name of Alan Adams, deceased IRA, for the benefit of Bonnie Adams. The other 50% of the money would be directly transferred into an IRA in the name of Alan Adams, deceased IRA, for the benefit of Carl Adams.

Result: Carl must use his 21-year life expectancy for calculating his required minimum distribution, while Bonnie can use her 29.6-year life expectancy for calculating her minimum distribution -- and therefore benefit from more tax deferral.

Trap: If they do not meet this December 31 deadline, Bonnie will be required to take distributions according to Carl’s 21-year life expectancy, because that’s the shortest life expectancy among the beneficiaries.