IRAs are more complicated than most people realize. It can be especially tricky to inherit an IRA. It is not unusual for IRA heirs to misunderstand these complicated vehicles. A wrong move or two triggers high taxes, often causing most of the IRA to end up with the IRS. Income taxes can take 35% or more of the IRA. Estate taxes can take another chunk.
Part of your estate planning should ensure that your heirs know what to do ? and what not to do ? with the IRA. Don’t expect that they will get good advice from the IRA custodian, an accountant, or other financial professional. We are in the early stages of the first generation to inherit IRAs, and few advisors are up to speed on the rules. Get good advice and pass it on to your heirs.
Here are the key inherited IRA mistakes and how to avoid them.
Disappearing documents. Your will or living trust has no effect on an IRA. Only the beneficiary designation on the form held by the IRA custodian determines who inherits the IRA. IRA owners often make the mistake of not designating a beneficiary or not updating the form after a beneficiary passes away. Another common mistake is the heirs misplacing or not being able to find the designation form. They have to depend on the custodian to have a current copy. Custodians don’t always have a copy, especially if it was filed many years ago or the original firm has merged one or more times.
In any of those cases, the custodian’s rules (if it has any) determine the beneficiary. It might be your estate, which is the worst result from a tax standpoint. Or it might be a spouse when you intended the IRA to go to your children.
Keep copies of your beneficiary designation forms in a file that is easy to find, and keep the designations up to date. Let your executor and heirs know where the forms are.
Ignoring spousal benefits. When a surviving spouse inherits an IRA, special options are allowed.
The inheriting spouse can treat the IRA the same as any other beneficiary can. Or the spouse can roll over the inherited IRA into a new IRA in his or her own name. The rollover allows the surviving spouse to start a new required minimum distribution schedule based on his or her own age. It also allows the spouse to name new beneficiaries.
The rollover often makes the IRA to last longer both during the spouse’s lifetime and when his or her beneficiaries inherit the IRA. Without the rollover, required distributions must begin soon after the IRA is inherited and might use a shorter distribution schedule than the spouse could establish under a rollover.
If the inheriting spouse is under age 59 1/2, however, and needs to begin taking withdrawals from the IRA, then a rollover would not be a good idea. Distributions before age 59 1/2 would be subject to a 10% penalty in addition to income taxes. But the 10% penalty does not apply when the RMDs come from an inherited IRA that is not rolled over.
Your spouse should know that he or she has options, and the consequences can be very different. Ensure that a good advisor is available to your spouse or leave some suggestions and guidelines for the spouse to follow.
Rolling over an IRA or changing the title. Non-spouse beneficiaries don’t have the same options as surviving spouses. For example, if your children inherit the IRA and roll it over into their own IRAs, then the entire inherited IRA would be fully taxable. The children would be treated as though the inherited IRA were distributed directly to them in cash. They might also owe a 6% excess contribution penalty for each year the money sits in their IRAs. If they roll over the inherited IRA to new, separate IRAs in their own names, they will owe only the income taxes.
Yet, many IRA custodians simply ask the heirs what they want to do with the IRA and don’t explain fully the consequences of the actions.
To prevent immediate taxation, an inherited IRA must be maintained, but it must be retitled by Sept. 30 of the year after the year of the original owner’s death. The new title must have the name of the deceased followed by deceased or “decedent.” Also included must be the beneficiary’s name and statements that the account is “for the benefit of” or “FBO” of the beneficiary and that it still is an IRA. For example: Max Profits, deceased, IRA FBO Hi Profits, beneficiary.
Spending down the IRA. Despite all their parents’ planning, an extremely high percentage of nonspouses who inherit IRAs take the balances as lump sums and spend them. That’s too bad. The heirs will pay income taxes on the entire balances. The amount they have left to spend depends on their income tax brackets and your estate tax bracket. In most cases, it is a fraction of the IRA’s original value.
Instead of spending the IRA on whatever their current needs are, heirs should let the IRA continue to compound tax deferred. They would end up with significantly more wealth than they would by taking a distribution. It probably even makes sense for the heirs to suspend their own 401(k) and IRA contributions or other savings to free their own cash instead of taking distributions from the IRA.
If your beneficiaries are likely to spend the entire IRA after inheriting, consider leaving them other property if you have it. It would be better to leave the IRA to other beneficiaries or charity. Heirs that plan to spend the inheritance quickly are better off receiving non-IRA assets, if that option is available to you.
Inheritors of IRAs who do not spend the balance right away must begin taking required minimum distributions over their life expectancies. The RMDs have to begin by Dec. 31 of the year following the year of the previous owner’s death.
Some heirs fail to begin taking the RMDs, so they pay penalties. Others take the RMDs under the wrong schedule and take larger distributions than they need to. Be sure your heirs who will not spend the IRAs have good information about how to determine the RMDs that will stretch the IRA the most.
Overlooking the tax deduction. Distributions from an inherited IRA are what the tax code calls income in respect of a decedent. This status entitles the recipient to an income tax deduction for the portion of the estate tax attributable to the IRA. Determining the deduction can be complicated. First, determine the amount of the estate tax paid that is attributable to the IRA. Then, the duration of the IRA distributions is estimated. Finally, a pro rata portion of the tax is deducted each year that a distribution is taken. Details are in IRS Publication 3920.
Not splitting the IRA. Until the 2001 and 2002 changes, when multiple beneficiaries inherited an IRA most of the time they had to share the IRA. That meant making joint investment decisions and computing required distributions based on the age of the oldest beneficiary.
Now, an inherited IRA can be split into separate IRAs for each of the beneficiaries. Then, each beneficiary makes individual investment decisions and takes required distributions based on his or her own life expectancy.
If splitting an IRA is what your heirs are likely to do, then check with your IRA custodian. Though the tax law allows IRAs to be split, the custodian doesn’t have to allow it. Be sure the custodian will allow a split and will not charge fees or penalties for the split. If it won’t, move the IRA to another custodian now.
Also, be sure your heirs know their options, the consequences, and the deadlines.
IRAs are the prime assets in many estates. They are surprisingly complicated financial accounts ? especially when it is time to take distributions. Few people know how to handle them. Be sure your beneficiaries have the information they need to make the right decisions. More details about IRAs and beneficiaries were discussed in the July 2002 and Sept. 2002 issues, which are in the Estate Watch section of the web site Archive. October 2003.