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Inherited IRA Horror Story

In anticipation of Halloween, I thought this real client horror story from Ed Slott & Co is timely.

The beneficiary of an IRA, Casey was 17 when she inherited the IRA worth approximately $170,000 at the time. The advisor made the (unfortunately all too common) error of moving the funds into an IRA in Casey's name rather than a properly titled inherited IRA. Casey had no idea if taxes were paid or were supposed to be paid; she relied on the guidance of the advisor.

Over the last 14 years, the account was moved several times to different IRA custodians and no one ever asked how a young person had such a large IRA. Casey only took out about $20,000 in the first three years she had the account and nothing since. Fast forward to the present when she needs some money so she makes a request to the advisor for a distribution. This prompted the current advisor to ask how she had an IRA that large at such a young age which uncovered the truth; it was an inherited IRA gone wrong!

Since a non-spouse cannot do a rollover, the transfer of funds from the inherited account to her own IRA was a taxable event the value of which should have been included on her income tax return for that year. Since it has been more than 3 years, the statue of limitations for audit has passed. However in a case such as this, the funds that went into Casey's IRA was an excess contribution subject to the 6% excise penalty per year until fixed. Normally this penalty would be filed on form 5329 which is considered a separate return, and since not filed, the statue of limitations never started.

The penalty is approximately $10,200 (6% of $170,000) per year for 14 years for a total of $142,800! The excess contribution amount would actually be reduced by the net eligible IRA contribution amount for each year which would make the penalty approximately $124,620 assuming full eligibility for the maximum allowable IRA contributions going back to 1998 and assuming she never made any of her own IRA contributions during those years.

Any distribution from the IRA Casey takes will be taxable. If she takes out the excess amount of $124,620 to pay the penalty, the tax due assuming a 25% tax bracket would be $31,155 plus the 10% early distribution penalty of $12,462 for a total of $43,617. Add these up and we have a total amount due of $168,237. All is not lost however because earning on the excess contributions are not distributed and if we assume a reasonable growth rate of 5% (which is below the 6% penalty amount), then her IRA would be worth approximately $336,588 minus the $168,237 penalty leaves her with $168,351 in her IRA. There would be the other penalties such as failure to file form 5329, accuracy related penalties, and interest due on those penalties for 14 years which would further reduce her IRA.

Note that had a distribution occurred when inherited, she would have paid the tax then presumably at lower rates because she was 17 and single, avoided the 6% annual penalty, and the 10% early distribution penalty which does not apply to beneficiaries of IRAs. More importantly if the original advisor was competent and set up a properly titled inherited IRA for Casey, she could have done the stretch and would still have the IRA today and paid much less tax along the way.

Don't let this happen to you or anyone you love. If you are not already, work with an Ed Slott Trained Master Elite IRA Advisor to make sure you and your beneficiaries don't have a scary story like Casey's to tell!

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