IRAs are the most valuable assets in many estates, often exceeding the value of the family homes. Despite this, IRAs often don’t get the attention in estate planning that they should.
Estate planning for IRAs requires more work and consideration than for most other assets. First, the IRA has to be fully integrated into your estate planning. Then, your heirs must be educated about the proper handling of Inherited IRAs. Many people overlook this step.
The IRS greatly simplified the rules for inherited IRAs in early 2001 and again in 2002. Yet, there still are traps for unwary heirs. Many financial advisors and financial institutions aren’t well-versed in all the rules, or they use the old rules instead of the new ones. It is worthwhile to be sure your heirs know a reliable estate planning or financial adviser to consult about IRAs they inherit. Otherwise, they could lose thousands of dollars.
Here are some estate planning facts your heirs need to know about inherited IRAs.
A major value of an IRA is its tax deferred compounding of income and gains. Usually an heir can continue that deferral for most of the IRA’s income and gains for many years. The exception is when the deceased’s name is taken off the IRA. When that happens, the IRA must be completely distributed to its new owners, who must pay the appropriate income taxes.
A few IRA sponsors still automatically take the deceased’s name off the IRA and put it in the new owner’s name. Make sure your IRA sponsor is not in that group. Also, make sure your heirs know not to switch any inherited IRAs into their own names.
Suppose Max Profits passed away, leaving an IRA to his beneficiary, Hi Profits. The correct new name on the IRA should be similar to: “Max Profits, deceased, for the benefit of Hi Profits.” If the beneficiary dies and a successor beneficiary receives the IRA, the account should remain in Max’s name, but for the benefit of the new beneficiary.
A spouse who inherits an IRA gets special status. He or she can roll over the inherited IRA into a new IRA in the spouse’s name and make a fresh start. This allows the inheriting spouse to begin required minimum distributions under a new schedule and to name new beneficiaries and contingent beneficiaries. If the spouse is under age 70 1/2, required minimum distributions do not have to be made even if the deceased spouse already began the distributions. Rolling over the IRA to a new IRA in the inheriting spouse’s name can greatly extend the account’s life and increase potential beneficiaries.
Before the IRS changed the rules in early 2001, the distribution schedule used by an IRA inheritor depended on whether or not the deceased owner had begun required minimum distributions. Now, the beneficiary simply starts a new distribution schedule based on his or her own life expectancy. The distributions are determined using the IRS Single Life Expectancy table, which is available on our subscriber web site. The first distribution for the inheritor needs to be taken by Dec. 31 of the year after the original owner’s death.
The IRS rules require an IRA inheritor to take a minimum annual distribution. A beneficiary, however, can take out as much more than that as he or she desires. Be sure your beneficiary knows that he or she can tap the IRA for whatever money is needed each year. The beneficiary also should realize that the distributions will be taxed.
In the old days, the choice of beneficiary was locked in when the owner turned age 70 1/2. Now the official beneficiary, known as the designated beneficiary, doesn’t have to be named until September 30 of the year after the owner dies. The first distribution then has to be made by that Dec. 31. The designated beneficiary can be named by the estate administrator. To take advantage of this flexibility, the owner should be sure to name a number of contingent beneficiaries. Only those named by the owner as primary or contingent beneficiaries can become designated beneficiaries.
This delay allows heirs to adapt the estate planning strategies to changed circumstances. Suppose the spouse is beneficiary of the IRA but inherited sufficient other assets to maintain his or her standard of living. It might make more sense for the IRA to go to a contingent beneficiary such as a grandchild. The spouse can disclaim the inheritance of the IRA and, if the grandchild is a contingent beneficiary, the grandchild could be named designated beneficiary.
Keep in mind that while the beneficiary does not have to make a first distribution until Dec. 31 of the year after the owner’s death, if the owner already had begun required minimum distributions the required distribution for the owner’s last year must be made by Dec. 31 of that year.
You can name multiple beneficiaries of an IRA in your estate planning stratergy. They can inherit equal shares, or you can have them inherit different proportions. If the beneficiaries continue the IRA as one account, then the age of the oldest beneficiary will determine the amount that must be distributed from the account each year.
The heirs can choose to split the IRA into a separate IRA for each of them. Each IRA would have its own distribution schedule based on the age of its new owner. This can be significant if there are meaningful age differences between the beneficiaries. It also can be helpful if the beneficiaries have different ideas about spending and investing the account.
Be sure that your IRA sponsor will allow the IRA to be split into separate IRAs for each beneficiary. While the tax law allows this, not all sponsors want to incur the cost.
While assets have to come out of the IRA under the minimum distribution schedule, a beneficiary does not have to sell investments and distribute cash. The law allows distributions to be made in property, and most IRA sponsors will arrange property distributions. If the IRA has stock or mutual fund shares the beneficiary wants to hold, and he or she doesn’t need the cash, the shares can be distributed.
At most sponsors, the beneficiary simply has to open a taxable account at the firm and complete a form identifying the property to be distributed from the IRA to the taxable account. Many sponsors will make the transfer without cost. That could save any transaction fees charged for selling shares to distribute cash.
When a distribution is made in property, the beneficiary should retain good records to avoid paying taxes twice. The distribution will be taxable income, whether it is paid in cash or in shares that are transferred to a taxable account. The beneficiary’s tax basis in the shares is the value that was included in income, not the original cost of the shares. Forgetting this, or not keeping a record of the share value on the distribution date, could result in paying taxes twice when the shares are sold.
There is a 10% penalty for most distributions made from an IRA before the owner is age 59 1/2. The penalty, however, does not apply to the beneficiary-owner of an inherited IRA. It doesn’t matter if the distribution is a required one or an optional one that exceeds the required amount. Many beneficiaries are incorrectly told that in addition to being taxed on the distributions they must pay the 10% early distribution tax.
All the options might not be available for a 401(k) plan. A 401(k) sponsor is not required to provide for long-term distributions. The law requires the sponsor only to allow distributions to last for up to five years. Some sponsors will allow the long-term options, but many won’t. If your 401(k) will not allow the long-term distribution options, then you or your heirs should roll over the account to an IRA.
The original owner of a Roth IRA doesn’t have to take required minimum distributions at any time. A beneficiary who inherits a Roth IRA, however, must take required distributions under the same rules as the beneficiary of a regular IRA.