Heirs routinely lose a large percentage of inherited IRAs to unnecessary taxes. The rules are simple, but they aren’t obvious and most heirs don’t know about them or even know enough to ask about them. If you don’t want a large portion or your hard-earned wealth and careful plans wasted, be sure your heirs know how to manage their new IRAs. Here are some key points.

* Spouses vs. non-spouses. A spouse who inherits an IRA has one big advantage over other beneficiaries. He or she can roll over the IRA to an IRA in his or her own name, providing the spouse with a fresh start for the IRA. The beneficiaries and required minimum distribution schedule can be reset. This often is a good idea for an inheriting spouse. But non-spouses who are beneficiaries cannot rollover the inherited IRA to a new IRA.

* Naming the IRA. Other than a spousal rollover, heirs should not make the mistake of changing the IRA to their own names or allow the custodian to do so. That would require a rapid distribution of all the IRA. When an IRA is inherited, the legal title needs to change, but in a specific way. An inherited IRA needs three things in its title: the name of the deceased owner; the word “IRA”; and the statement that it is “for the benefit of” the beneficiary. An appropriate title is “Max Profits IRA (deceased), F/B/O Hi Profits, beneficiary.

* Deadlines. After inheriting an IRA, beneficiaries have options and requirements. Required minimum distributions must begin, for example, and joint beneficiaries can split the IRA into separate IRAs for each beneficiary. But these actions must be taken by the end of the year after the year in which the owner died. Failure to act by the deadline can result in higher taxes than would otherwise be paid.

* Splitting the IRA. A single IRA often is left to multiple beneficiaries. For example, Max Profits can name his three children as equal beneficiaries. If they decide to share the IRA, required minimum distributions are based on the age of the oldest beneficiary. The children also would have to agree how to invest the IRA and on rules for taking distributions beyond the required minimums. An alternative is for them to split the IRA into a separate one for each beneficiary. Most IRA custodians allow the IRA to be split in this way. Beneficiaries need to know this option is available and how to exercise it.

* Distributions. Most heirs tend to withdraw all the money from an inherited IRA quickly, pay taxes, and spend the after-tax amount. (Some forget about the taxes and spend all the money. Then they scramble to pay the taxes the following April.) When beneficiaries prefer to use the IRA’s tax deferral, they should know how to compute required minimum distributions. The amount of the RMDs depends on whether or not the original owner was already taking RMDs, and the beneficiary has two options in each case.

Suppose the deceased owner was not over age 70½ and had not begun RMDs.

The first option for the beneficiary is to begin taking distributions using the beneficiary’s life expectancy. The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the fifth year following the year of the original owner’s death. In the second option, the distributions can be taken on any schedule the heir wants. For example, the entire amount could be left in the IRA until the end of the fifth year. Or roughly equal amounts could be taken each year. Or money could be withdrawn as needed, with whatever is left in the IRA distributed by the end of the fifth year.

The first option is best for an heir who wants to use the IRA’s tax deferral for as long as possible. Remember, an amount exceeding the RMD for the year can be withdrawn at any time, so this option doesn’t limit annual distributions. The second option is for an heir who doesn’t intend to use the long-term tax deferral of the IRA. The five-year period gives the beneficiary time to search for ways to reduce income taxes on the distributions.

The options are a little different when the deceased owner already started RMDs.

The first choice again is for the heir to take annual installments over the beneficiary’s life expectancy. The second option does not include a five-year rule. Instead, the heir can continue the RMDs on the schedule begun by the deceased owner, using what would have been the deceased’s age and life expectancy each year. The IRS says that the second method is the default method if the beneficiary does not make a selection or the IRA custodian does not name the other method as the default.

* An overlooked deduction. This deduction is less important under the new estate tax law. But if an estate pays federal estate tax, it can save money for the heirs. Most taxpayers and even many tax advisers are unaware of the deduction for “income in respect of a decedent.” It essentially is a deduction for the estate taxes that were paid on the IRA. The deduction is best explained with an example.

Suppose someone left a large estate with an IRA. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA’s dollar share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators, available free on the IRS web site, www.irs.gov.

* Disclaimers. The details of who should inherit an IRA can be left to your executor who, along with family members, can determine from both a financial and tax standpoint who should be the Designated Beneficiary. The Designated Beneficiary does not have to be selected until Sept. 30 of the year following the year of the owner’s death. The first required distribution does not have to be made until Dec. 31 of that year. But the Designated Beneficiary must be one of a group of primary and contingent beneficiaries named by the account owner.

The way to take advantage of this provision is for you to name both primary and contingent beneficiaries. After your heirs and executor decide who should inherit, those who are ahead of that person in the beneficiary chain can disclaim their interests.

There is a procedure in the tax law for making qualified disclaimers. Your heirs and executor should be aware of your intentions and this process, and you should give the executor guidelines for making the decision and advising the beneficiaries.

All your work of growing and preserving the IRA over the years and planning your estate could come to naught when your heirs mishandle the IRA. You can find more details and strategies for heirs in my report, Bob Carlson’s Guide to Inheriting IRAs. Be sure they know their options and obligations and have good advice on how to handle the inherited IRA.