Do you have an individual retirement account (IRA) that you’re planning to leave to your heirs? Or do you expect to inherit an IRA from a parent, relative or friend at some point in the future? Since retirement accounts make up the majority of many people’s estates, you probably answered “yes” to one, or both of these questions.
If so, now — not later — is the time to understand the IRA beneficiary rules and options.
Why? Because one wrong decision can lead to expensive consequences.
If you inherit an IRA, you’ll have some important decisions to make and strict deadlines for making them. Making the wrong choice or not making a choice by a deadline could trigger an unnecessary tax bill and result in forfeiting the opportunity for future tax-advantaged growth. One wrong move and the entire IRA could be taxed, rather than tax-deferred.
Mistakes are painfully common when IRAs are passed to heirs. Most financial advisors don’t know all the rules. Don’t count on your account’s custodian to provide customized advice either. The problem is that a mistake made on the part of the custodian, or bad advice from an advisor, leaves beneficiaries footing the tax bill.
Here are four important tips for ensuring that your inheritance is not diminished by paying unnecessary taxes.
1. Double-check your beneficiary forms
The beneficiary form on file with the custodian of an IRA controls both who inherits it and its ability to be stretched out. Stretching out the tax benefits of retirement accounts is tricky — and in some cases impossible — if the original owner of the accounts didn’t fill out his beneficiary forms correctly.
To give your heirs maximum flexibility, name both primary and alternate individual beneficiaries. For example, you could name your spouse as primary beneficiary and kids as alternates, or your kids as primary and grandkids as alternates. Your primary beneficiary then has the option of “disclaiming” or turning down the account, enabling it to pass to the younger alternate.
If people other than a spouse are named as heirs, they must begin taking distributions from the account by Dec. 31 of the year after inheriting. Because they can draw these out over their own expected life spans, they can potentially benefit from decades of tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.
By contrast, if an estate is named as beneficiary, the stretch benefit of tax deferral is cut short. If it’s a Roth IRA, all funds must be withdrawn within five years. For a traditional IRA, the same rule applies unless the former owner was already 70 ½ years old — the age at which a traditional IRA owner must begin cashing out. In that case, the distribution rate for the heir is based on the age of the person who died.
If two or more people are named as beneficiaries, you may want to ask the custodian to split it into separate inherited IRAs, which could allow a longer stretch period for the younger heirs.
What if there’s no beneficiary form on file? Heirs are at the mercy of the IRA custodian’s default policy. Few custodians will pass on an IRA directly to the kids without a beneficiary form.
2. Inherited IRA rules are different
If you inherit a retirement account, don’t do anything until you know exactly what rules apply. With your own IRA, you can take the money out and redeposit it in another IRA within 60 days without penalty. Not so with an inherited IRA. All transfers must be directly from one IRA custodian to another. Be sure to specify a “trustee-to-trustee” transfer.
Also, unless you’ve inherited from a spouse, you must retitle the IRA, including the original owner’s name and indicating it is inherited, e.g., “John Smith, deceased, inherited IRA for the benefit of Suzie Smith, beneficiary.”
3. Distribution rules are different
If the late IRA owner was 70 ½ or older, beneficiaries must make sure the owner’s mandatory distribution for the year of death is withdrawn before doing anything else.
The minimum distribution is calculated differently than for your own IRA. Rather than using the table used by IRA owners, you take the balance on Dec. 31 of the previous year and divide it by your life expectancy listed in the IRS’s “single life expectancy” table. The next year, you use the same life expectancy, minus a year. (With your own IRA, you take a new life expectancy from a table each year.)
4. Spouses have more options
A spouse has options not available to other beneficiaries. Let’s assume the beneficiary is the wife. She can roll the assets into her own IRA and postpone distributions from a traditional IRA until she turns 70 ½. Keep in mind that, like other IRA owners, she may have to pay a 10 percent early-withdrawal penalty if she takes money before age 59 ½ from her own IRA. So a young widow should generally wait until after reaching 59 ½ to do the rollover.
Lisa Hay, CPA, Author and Financial Planning expert, has written a user-friendly guide, INHERITED IRA RULES: How to Minimize Inheritance Taxes with Stretch IRAs and Roth IRAs, to help you navigate the labyrinth of rules regarding inherited IRAs.
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