There is a lot of confusion about what you can do with inherited IRAs.

There are a lot of things to think about: There are required minimum distributions to consider. You also need to understand how to name your beneficiaries. There are special rules and exceptions for spouses.

Mistakes can be costly. Not satisfying the RMD can cost you 50% of what you should have taken. That goes for withdrawing too little or not withdrawing at all. In addition to income tax, you could pay a 10% penalty for if you take out money before turning 59½.

We will unpack these and other issues surrounding inherited IRAs. Get your pen and paper ready. We have a lot to cover.

Boomer wealth transfer

According to a Pew Research Center study, Boomers (ages 52–70 in 2016), totaled 74 million. Millennials (ages 22-35 in 2016), on the other hand, totaled 71 million. The study goes on to say that in 2019, millennials numbers are expected to increase to 73 million while Boomers decrease to 71 million.

As the boomer number shrinks over the coming years, their wealth, estimated at anywhere from $30 trillion to as high as $60 trillion gets passed on to the next generation. That means their millennial and Generation X offspring will be inheriting significant amounts of money. Even taking the low end of that number means over the next couple of decades, a lot of wealth will change hands.

The U.S. News reports that boomers stand to inherit $11.6 trillion from their parents and grandparents. Much of that transfer will come in the form of retirement accounts, primarily IRAs, and Roth IRAs

The foundation

Many parents haven’t discussed their estate plans with their kids. In my work with clients, I find three primary reasons for this.

• They haven’t done proper planning themselves.

• They don’t want their kids to know what they have.

• There are tensions and competition among the siblings.

Having an estate plan in place goes a long way toward squelching the sibling rivalry. That is, at least from a legal standpoint.

It likely won’t stop the arguing among them. It will, however, decrease the chances of legal challenges to the estate.

That’s why it’s so important for all of us to have a properly drafted estate plan in place. It’s always best to let all of the beneficiaries know what your desires are. I realize that won’t happen in a lot of cases for a lot of reasons. In my experience of working with clients over the last couple of decades, having these conversations before we pass reduces more significant problems down the road.

Losing a parent is hard enough. Having to sort out their estate because of poor planning adds layers of stress and grief that could easily be avoided.

Beneficiary designations

Primary

Remember, IRAs pass via beneficiary designation. They don’t have to go through the estate settling probate process. They transfer directly to the named beneficiary or beneficiaries on each IRA account.

IRAs and other retirement accounts can have primary and contingent beneficiaries. The primary beneficiary is the first in line to inherit the IRA. If married, the spouse is the most common primary beneficiary. If the spouse is the sole primary beneficiary, they get 100% of the value of the IRA at the owner’s death.

There can be more than one primary beneficiary. If a spouse dies, the IRA owner needs to name a new beneficiary. This step is an important one. Leaving the deceased spouse as the beneficiary means that when you die, the IRA will go to the estate. As such, it would be subject to the probate process and would pass to the beneficiaries of the estate.

The IRA beneficiaries can be different from the overall estate beneficiaries. Often, in a family, they are the same. Remove all doubt and name new beneficiaries if your spouse dies before you do.

Contingent

Contingent beneficiaries are second in line behind the primary. It is a common practice when naming beneficiaries to name both primary and contingent beneficiaries.

Let’s say you are married with two children. In naming beneficiaries, you might designate your spouse as primary (100%) and your two children as contingent (each child at 50%). If both you and your spouse die in a plane crash, your kids will each get 50% of your IRA.

I know it isn’t easy to think about all of this, much less talk about it. But here’s the key question: Do you want to leave a mess for your heirs to clean up because you didn’t want to have the conversation? Though some don’t care, most of us would never want to do that.

Naming IRA beneficiaries is one of the least painful parts of the process. Do the easy things like that first. Start with naming primary and contingent beneficiaries to all retirement accounts (IRAs, Roth IRAs, 401(k), 403(b), etc.).

Inheriting IRAs

Now that we have our beneficiary designations in place, let’s talk about what happens when they inherit our retirement accounts. Rules are different for spouses and non-spouses. Requirements are different for those dying before age 70½ (age for RMDs) and for deaths occurring after age 70½.

In most cases, it’s likely you contributed to your IRAs pretax. In other words, you never paid income tax on the contributions or their earnings. The RMD is the IRS’s way of getting that tax money back.

Roth IRAs do not have RMDs. Since your contributions were after-tax, they don’t require RMDs. If you hold the Roth IRA for five years, you can withdraw that money tax-free as well. Many investors convert their traditional IRAs to Roth IRAs over several years. Many do it all at once. You pay taxes on the converted dollars for the year in which you the conversion is complete.

In other words, if you convert a traditional IRA to a Roth IRA this year, you will owe taxes on the converted amounts when you file your taxes the following year. In addition to making future withdrawals tax-free, it eliminates many of the issues that come with inherited traditional IRAs.

Rules for inherited Roth IRAs are much less restrictive than traditional IRAs.

Spousal beneficiaries

Spouses have the most options when inheriting IRAs. The assumption for this section is that the spouse is the sole primary beneficiary.

In this case, the spouse has three options.

• Stay as the beneficiary of the inherited IRA.

• Spousal rollover to their account.

• Make the IRA their own.

• Stay as beneficiary.

The spouse still needs to change the title of the IRA from the deceased spouse name to an inherited IRA. Each custodian may have different rules for titling. For example, it might be something like, “John Jones, deceased 1/1/2018 F.B.O. Mary Jones, beneficiary.” It could also be something that includes the term inherited or beneficial, like, “Mary Jones, as the beneficiary of the inherited IRA of John Jones, deceased, 1/1/2018.”

The bottom line is the title must show that the IRA is an inherited account. The spouse would then name a beneficiary of the inherited IRA.

If the owner died before reaching age 70½, no RMDs are due. No RMD is due until the deceased spouse would have reached age 70½.

If the owner died after age 70½, the spouse is subject to the RMD rules. The spouse would use their age and calculate the RMD based on their single life expectancy. The benefit a spouse has is the ability to recalculate the life expectancy each year for that age. That offers the ability to stretch out the payments for a longer period potentially.

If the spouse of the inherited IRA dies before reaching age 70½, their beneficiaries can use their life expectancies to calculate the RMDs. That offers the opportunity to stretch out those payments over an even more extended period.

Spousal rollover

The rollover option is only available to a spousal beneficiary. It offers the opportunity to roll the inherited IRA over into an individual account. They can do this via direct or indirect rollover. Once the money is in the new account, it is treated as if the spouse owned them the entire time. If they are under age 59½, any distributions would be subject to taxes and the 10% early distribution penalty. Once made, the decision is irrevocable. Make sure you think it through before making this decision.

In general, it’s better to leave the account as an inherited IRA until after reaching age 59 ½. Waiting avoids the 10% additional penalty and offers much more options and flexibility to the spouse and their beneficiaries.

Treat the account as their own

Though the least used option, treating the account as their own is available to the spouse. However, the tax consequences with this option are the same as if the spouse did a spousal rollover to their account.

In most cases, there is rarely a reason for a spouse to treat the IRA as their own. Since it is an option, I’ve included it in the discussion.

In most cases, the choice for the spouse comes down to the first two choices. And the choice is clear on which to choose the vast majority of the time. If under age 59½, it’s best to keep the account as an inherited IRA to avoid the early distribution penalties on distributions. If over age 59½, it makes sense to do the spousal rollover. There would not be an early distribution penalty for withdrawals. The spouse would have all the advantages as if they owned it the entire time.

Designated vs. non-designated beneficiaries

Before going too far into nonspousal beneficiaries, let’s quickly cover designated vs. non-designated beneficiaries. In general, designated beneficiaries are individuals named on the beneficiary form of the IRA. They can be spouse and non-spouse. There is also a special provision for a type of trust, called a see-through trust, that is treated as if it’s an individual. There are advantages to this type of trust we will discuss shortly.

Non-designated beneficiaries are non-individual entities. Examples are the estate, charities, and trusts that don’t qualify as see-through trusts. Whenever possible, it’s best to name designated beneficiaries to preserve the use of what’s called the stretch IRA.

The stretch IRA allows the beneficiary to extend any required distribution over a longer life expectancy. Doing so reduces the annual taxable income, increases the length of time the beneficiary can take that income and increases the opportunity for the account to grow for a longer period.

We’re only going to cover what happens with designated, nonspousal beneficiaries here.

The disclaimer

Though not often used, the disclaimer option may make sense in some situations.

In simple terms, a disclaimer allows the beneficiary to refuse the money from the IRA to which they are beneficiaries, to disclaim it. In a disclaimer, it’s as if the beneficiary predeceased the IRA owner. A disclaimer can either be qualified or nonqualified. If qualified, it’s as if the asset being disclaimed never belonged to the individual named as beneficiary. That’s the most advantageous form of disclaiming.

Why would someone disclaim? One reason might be they don’t need the money. Perhaps they are set financially, don’t want to incur the taxes, or just want to leave it to their children. If the children inherit the IRA, they will be able to spread the distributions out over their lifetime. Depending on their age, that could be a very long time.

Another reason to disclaim might be creditor protection. If the beneficiary lives in a state that doesn’t extend creditor protection to individual IRAs, disclaiming protects those funds.

Disclaiming can be full or partial. For example, if the IRA balance is $100,000, the beneficiary can disclaim, say $50,000 and inherit the remaining $50,000. It’s important to at least know about this option. There may be a time when you want to use it.

Rules for disclaiming

When requesting a disclaimer, it must satisfy four conditions.

• It must be in writing – A disclaimer is a legal document. As such, it should be drafted by a competent estate attorney.

• It must be received in a timely manner by the IRA custodian – Typically, that period is within nine months after the death.

• It must be executed before the beneficiary accepts an interest. That doesn’t mean the beneficiary takes the money. One example would be if they make investment decisions on the account, that’s considered accepting an interest.

• It must pass to someone other than the person making the disclaimer. This one is tricky. If the beneficiary disclaims and the assets revert to the estate of the owner and they are a beneficiary of the estate, the disclaimer won’t work. The exception is for a spouse. If they are beneficiary of the IRA and the assets end up in a trust where the spouse is a beneficiary, it can work. The caveat is that the spouse cannot exercise any control of those assets.

It’s necessary for beneficiaries considering disclaiming or any option on these funds to get the proper advice. Don’t make decisions without understanding what your options are. Let me emphasize again the importance of using a competent attorney to set these up.

The stretch IRA

The stretch IRA allows the beneficiaries to spread the required distributions over the longest possible periods.

Once again, it’s important to understand the rules to take the fullest advantage of the stretch option.

With a non-spouse designated beneficiary, the age at death of the IRA owner doesn’t matter. Whether the owner dies at age 50 or age 80, the stretch IRA still works for the beneficiary. The beneficiary does not have to take their distribution in the year of the owner’s death. If, however, the IRA owner had an RMD due in the year of death that had not been taken, the beneficiary must take that RMD before the end of the year of death. If the owner had not yet started taking their RMD, the beneficiary is not required to take out anything in the year of death.

The following year, they must begin to take the required distribution and every year thereafter. Distributions calculations are made based on the on Dec. 31 balance in the prior year. That’s often where mistakes get made. Be sure to use the proper valuation date to avoid the severe penalties for underpayment.

Once you determine the year-end balance, you must use the proper life expectancy table to calculate the payment. All beneficiaries use the Single Life Expectancy Table.

IRA owners, on the other hand, use either the Uniform Lifetime Table or the Joint Life Expectancy Table. If beneficiaries use either of these tables, they will likely be penalized for underpayment.

Calculating the stretch IRA deduction

Remember, the starting point for the calculation is the Dec. 31 value in the year the IRA owner died. The year to use for the beneficiary age, is the year following the owner’s year of death.

Here’s an example of how to calculate the stretch IRA payment.

Ron was 50 years old when his mother died in 2017. When she died, Ron’s mother was age 68. She had not yet begun her RMDs. Because of that, Ron is not required to take an RMD in 2017. In 2018, Ron will be 51 years old. Going to the Single Life Expectancy Table, we see that the factor for a 51-year-old is 33.3. If the 12/31/2017 IRA account value was $100,000, Ron’s 2018 required distribution is $3,003.00 ($100,000/33.3= $3,003). In every year going forward, Ron will subtract one from the previous year’s factor to calculate the current RMD. In other words, the 2020 factor will be 32.3 (33.3-1). The account value is still the Dec. 31 value of the prior year.

Most younger beneficiaries should use the stretch IRA to minimize the income and taxes paid each year. Doing so maximizes the potential growth in the account by taking out lower amounts of income. If the beneficiary needs the money, then the stretch IRA is not the best option.

They may need to take a lump sum. Doing so means the account is fully taxed for the year of the distribution. That potentially puts the beneficiary into a higher tax bracket for that year. Because of the tax bill, they will get a much smaller amount of money.

Another viable option is the five-year option. The five-year option spread the income and tax bill over five years. For those who need or want the money quicker, this may be a better option.

Final thoughts

Inheriting IRAs can be complicated. It’s important to understand the rules and all options available to you as a beneficiary. Even with all that’s been covered in this post, there is much more to learn about inherited IRAs.

These are the most common options for spousal and nonspousal beneficiary designations. The rules in naming a trust as beneficiary are far too complicated to include in this post.

I have not attempted to cover the rules for inheriting a Roth IRA. There are tax benefits available for beneficiaries of Roth IRAs that aren’t available in traditional IRAs. There are still rules that need to be followed. We’ll add that to the list of topics for future posts.

It is likely that at some point, many of you will inherit an IRA. It’s crucial to understand the rules to get the most out of your distribution. It may be equally important to avoid the pitfalls that come from errors.

This article originally appeared on Money With A Purpose. It has been republished with permission.

Fred Leamnson is founder and president of Leamnson Capital Advisory and is the author of the blog Money With a Purpose.