One of the most difficult financial tasks facing a surviving spouse is how to handle the individual retirement accounts (IRAs) and other qualified retirement plans.
Mistakes often are made with inherited IRAs, whether they are inherited by spouses, children or others. It is understandable. Retirement accounts are treated differently than most other assets in the estate. The rules for inherited IRAs aren’t intuitive or simple. But it’s important to be sure heirs know what to do, because making the wrong decision with the inherited retirement account can trigger thousands of dollars in extra taxes.
This month we’re going to focus on the choices for surviving spouses. Surviving spouses have more options with inherited IRAs than other beneficiaries. Those options provide the opportunity to increase the after-tax value of the IRA but also create more potential pitfalls.
A surviving spouse who is a beneficiary of the deceased spouse’s traditional IRA has the same choices
as any other IRA beneficiary. But there’s a twist to one of them, and the surviving spouse has an additional option.
• One option is to distribute all of the IRA assets within five years of the original IRA owner’s death.
The IRA can be distributed on any schedule within those five years. All the distributions will be included in gross income and taxed in the same way they would have been to the original owner.
This usually is the least attractive option from a tax planning perspective. But it’s one to be considered
when there’s a need for the cash. It is important to note that, regardless of the age of the beneficiary, the 10% tax on distributions made before age 59½ doesn’t apply to distributions following the death of the original owner. Only income taxes will be due.
• The second option is to establish the account as an inherited IRA. The legal title of the IRA must be changed to reflect that it is an inherited IRA held for the benefit of the surviving spouse. Each IRA
custodian uses its own particular wording, but the title must have the name of the original owner, state
that the owner is deceased, name the beneficiary and state that the IRA is “for the benefit of ” or “FBO” the beneficiary. For example: Max Profits, deceased, IRA FBO Rosie Profits.
So far, these rules are the same as for beneficiaries who aren’t surviving spouses. Here’s one area where
the rules are different for a surviving spouse.
When a non-spouse beneficiary establishes an inherited IRA, required minimum distributions (RMDs) must begin by Dec. 31 of the year following the original IRA owner’s death.
Surviving spouses follow the same rule if the deceased spouse had already reached the age to begin
RMDs, 70½. But when the spouse passed away before reaching RMD age, the surviving spouse doesn’t
have to begin RMDs from the inherited IRA until the deceased spouse would have been age 70½. When
the RMDs begin, the surviving spouse can choose to use his or her own life expectancy or can take the
RMDs based on the age the deceased spouse would have been.
The additional option for the surviving spouse is available only if the surviving spouse is the sole primary
beneficiary of the IRA. If others share as primary beneficiaries, then all are treated as non-spouse beneficiaries. Keep in mind that the surviving spouse can take distributions in any amount before the RMDs begin.
• The third option, and one that’s unique for surviving spouses, is the spousal rollover, or fresh start, IRA. The surviving spouse can use this option for his or her share of an IRA even when there are other primary beneficiaries. Under this option, the surviving spouse rolls over the assets to his or her own IRA. The rollover can be done by the IRA custodians, or the surviving spouse can take a distribution and deposit that amount into his or her own IRA within 60 days. The spousal IRA can be a new IRA set up for this purpose or an existing IRA. The assets also can be moved tax-free to any other qualified retirement plan account of the surviving spouse, such as a 401(k) account.
Once a spousal IRA is created, it is treated as though it always were the surviving spouse’s IRA. No
reference is made again to the previous IRA, and it is not considered an inherited IRA. The surviving
spouse names new beneficiaries. The RMD schedule is determined solely by the surviving spouse’s
age. That’s why it’s called a fresh start IRA. Once executed, a spousal rollover is irrevocable.
• A fourth option is very similar to the third option. The surviving spouse simply treats the inherited
IRA as his or her own IRA. This has the same effects as the spousal IRA, but it rarely is done this way. Usually, the spousal rollover is used to avoid any misunderstanding about the surviving spouse’s intentions.
The best option usually depends on the surviving spouse’s age. Remember that after a spousal rollover,
the IRA is treated without reference to the previous IRA. That means when the surviving spouse is under
age 59½, the 10% penalty on early distributions applies to distributions from a spousal rollover IRA, unless the surviving spouse qualifies for one of the other exceptions.
But the 10% early distribution penalty doesn’t apply to distributions from an inherited IRA. If the
surviving spouse is less than age 59½ and might need to take distributions before reaching that age,
then the inherited IRA likely is the best option. When the surviving spouse is older than age 59½, then
the spousal rollover usually is the preferred option.
Another important point is that the spousal rollover can be executed at any time. A younger surviving
spouse first can treat the IRA as an inherited IRA. Then, after reaching age 59½ (or at any other time), a
spousal rollover can be executed with the remaining IRA balance.
Choosing a strategy can be more difficult when the surviving spouse was substantially younger than the
deceased spouse. In that case, under the inherited IRA, the surviving spouse might be forced to begin
RMDs at a relatively early age, even before turning age 59½. The surviving spouse might not want to
begin RMDs that early, and the way to avoid that would be to choose a spousal rollover. The tradeoff is that if money is needed from the IRA after the rollover, the surviving spouse will owe both income taxes and the 10% early distribution penalty. The better choice depends on how likely the spouse is to need to take distributions before age 59½.
The effects on the next generation of beneficiaries also should be considered.
When the surviving spouse chooses the inherited IRA option and passes away before starting RMDs,
then the next generation of beneficiaries must begin RMDs by the end of the year following the surviving
spouse’s death, but they can use their own life expectancy to compute those RMDs. When the surviving
spouse was taking RMDs because the first deceased spouse would have reached age 70½, then the next
generation of beneficiaries must continue the distribution schedule the surviving spouse was using.
When the spousal rollover was used, the rules are a little different. If the surviving spouse hadn’t begun
RMDs from the fresh start IRA at the time of his or her death, then the next generation of beneficiaries
must begin RMDs by Dec. 31 of the following year using the oldest beneficiary’s life expectancy. If the
surviving spouse had begun RMDs, then the next generation has the option of taking the RMDs using either their own life expectancy or using the distribution schedule established by the surviving spouse.
There’s one other angle to consider. I regularly advise people not to name their estates as IRA beneficiaries or not to fail to name an IRA beneficiary. That’s because the potential for deferral is lost when an entity other than a natural person is the beneficiary. The IRA must be distributed within five years. But there’s a narrow exception when the surviving spouse is the sole executor of the estate and also the sole beneficiary of the IRA proceeds that pass through the estate. In that case, the surviving spouse still can execute a spousal rollover within 60 days after proceeds are received from the IRA.
But the surviving spouse can’t treat the IRA as an inherited IRA. (IRS Private Letter Ruling 201618011)
That’s a narrow exception and not one that you should rely on.
If you want your spouse to inherit your IRA and have the widest range of options, you should name him or her as the primary beneficiary. Then, be sure your spouse will be informed of the options for handling the IRA and how to choose the better option.
There’s one other point to note. The same rules generally apply to both IRAs and employer retirement
plans, such as 401(k)s. But employers are allowed to place additional limits on beneficiaries, whether
spouses or non-spouses. For example, some employer plans require the full account to be distributed or
rolled over to an IRA within a short period. If you’ll leave money in a 401(k) or other employer plan, be
sure to check the options and restrictions for beneficiaries and make those available to your beneficiaries.