Do you want to hand your heirs big tax problems? Would you like to hand the IRS a sizable chunk of your inheritance? Probably not. But if you misunderstand the rules when it comes to inherited IRAs, you just might. Here are some mistakes that IRA owners and IRA heirs often make.
- Many clients think that a will or a trust can facilitate the transfer of IRA assets.
IRAs don’t pass to heirs through wills or trusts (a few rare exceptions aside). The beneficiary form takes precedence. This is a form the IRA owner filled out and signed when opening the account.Problems arise when:
- • The IRA owner dies without designating a beneficiary;
- • The designated beneficiary has passed away before the IRA owner; or
- • No one can find the beneficiary form (not even the IRA custodian,
i.e., the financial institution that hosts the IRA).
In these circumstances, IRA heirs commonly end up playing by the IRA custodian’s rules. The resulting beneficiary often ends up with the IRA owner’s estate and must be paid out within five years of the owner’s death. This is usually a very undesirable tax consequence. It might be a contingent beneficiary and perhaps a very undesirable emotional consequence. The best thing to do is to keep the beneficiary form handy, keep it up to date and to let your heirs know where it is.
- Too often, non-spousal IRA heirs see the inherited assets as money to spend.
They withdraw the entire IRA balance as soon as it’s given to them. Unfortunately, what happens is all that money will be subject to federal income tax. Due to this move, they may lose a third of the IRA assets (or more).Instead, non-spousal beneficiaries need to open an inherited IRA to house the inherited assets and simply take Required Minimum Distributions (RMDs) from that inherited IRA under the appropriate schedule. This will allow the beneficiary to stretch the IRA over the course of his or her lifetime.With a traditional IRA the age of the original account holder is a big factor. If the original IRA owner is under age 70-1/2 and hadn’t taken any RMDs, when the beneficiary inherits the IRA, distributions must occur within five years of the original IRA owner’s death. Under this five-year rule, the entire account balance must be distributed to the beneficiary within those five years. If the account holder was over age 70-1/2 and had already taken RMDs, then the inherited IRA assets may be distributed gradually over the projected lifetime of the beneficiary according to IRS tables. If you don’t have to go by the five-year rule, the invested IRA assets may keep compounding across many years with the added benefit of tax deferral.You can also disclaim or renounce some or all of the inherited IRA assets, which could be a wise move for tax purposes if you don’t need the inherited funds.
- When a spouse dies, the surviving spouse that inherits an IRA doesn’t review all options to choose carefully.
Here are the options that should be considered:
- Roll over the assets into a beneficiary IRA. There are compelling reasons to go with the rollover. The widowed spouse can set up an RMD schedule based on his or her life expectancy. This second point is really important, because the rollover allows the surviving spouse to put off the RMDs that would otherwise soon need to happen. In fact, the surviving spouse can wait until the year in which the original IRA owner would have turned 70-1/2 to start taking required withdrawals from the IRA.
- Convert the inherited IRA into your own IRA. If the spouse converts the IRA into his or her own IRA, the surviving spouse can name a beneficiary for the inherited assets, keep contributing to the IRA, and potentially avoid RMDs until he or she turns 70-1/2.
- Take a lump sum distribution. If the widowed spouse wants to take distributions from the inherited IRA before age 59-1/2, a rollover is probably not the way to go. If that is the desire, those withdrawals will be slapped with the 10% early withdrawal penalty plus the requisite income taxes once it’s rolled over. Either way, there will still be income tax consequences to be considered.
- Disclaim up to 100% of the deceased spouse’s IRA assets. Or, a surviving spouse who doesn’t really need inherited IRA assets can disclaim them, meaning that they will go to the named contingent beneficiary. Sometimes this can be a wise move for tax purposes. The surviving spouse cannot direct where the IRA assets go. Disclaiming an asset acts as if you have predeceased the original owner.
- Non-spousal heirs fail to re-title an inherited IRA.
If this isn’t done by the year following the year in which the original IRA owner passed, then there can be no direct rollover of the inherited IRA assets and no stretch for those assets. A non-spouse beneficiary cannot roll inherited IRA assets into their own IRA. It must be re-titled as an inherited IRA. The IRS will treat those inherited IRA assets like a fully taxable cash distribution with 100% of it subject to income tax.
The bottom line is that the beneficiary must think before he or she acts in order to avoid unwanted taxes and penalties.