How Heirs Can Secure the Stretch IRA

Estate plans often go awry simply because beneficiaries were not aware of the actions they needed to take or that the estate owner wanted taken to fully implement the plan. IRAs are the assets beneficiaries are mostly like to handle poorly.

In a recent IRS ruling, an IRA beneficiary avoided a tax disaster, but she could have avoided significant penalties with better information and guidance.

The key benefit of an IRA is tax deferral. The goal of most IRA owners is the Stretch IRA. Tax rules force distributions to begin after an owner is age 70½ and after an IRA is inherited. The Stretch IRA is one that uses the rules to maximize tax deferral, reducing required distributions to the minimum. The IRS recently showed that it can be sympathetic to a beneficiary who wants a Stretch IRA.

When an IRA is inherited by a nonspouse and the owner had not begun required minimum distributions, the beneficiary has two choices. Required minimum distributions can be taken over the beneficiary’s life expectancy, with the first distribution to begin by Dec. 31 of the year after the owner’s death. Or the IRA can be distributed completely within five years after the owner’s death. Under the second option, the distributions can be taken in any pattern as long as the IRA is empty after five years.

If a required distribution is not made, the penalty is 50% of the amount that was required to be distributed.

In a recent private ruling, the taxpayer inherited an IRA. The owner had not started required minimum distributions. For the first two years, the beneficiary did nothing. In the third year, she took distributions equal to the total required distributions for the first three years using her life expectancy. She also paid the 50% penalty for failing to take the first two years’ distributions on time. She asked the IRS to rule that she could continue taking distributions over her life expectancy and not be required to empty the IRA over five years.

In Private Letter Ruling 200811028 the IRS ruled in the beneficiary’s favor. She never elected the five-year option, and the custodial documents for the IRA indicated that the life expectancy distribution method was the default. Failure to take distributions the first two years was not considered a de facto election of the five-year option.

This a more lenient than the old rules in effect before the regulations issued by the IRS in 2001 and 2002. Under the old rules, the five-year option was the default. A beneficiary was stuck with it unless an affirmative election of the life expectancy method was made. Now, a beneficiary automatically has a Stretch IRA unless the five-year option is elected.

Yet, this beneficiary needlessly paid a penalty of 50% of the first two years’ required distributions. Her father, the IRA owner, apparently assumed she would be aware of the IRS regulations and would begin taking distributions as required. Since the daughter was in her early thirties, the difference between taking distributions over five years and over her life expectancy was substantial. The penalties, and the fear of having to empty the IRA within five years, could have been avoided if the owner had left written instructions to the beneficiary or arranged for her to consult with an adviser after inheriting the IRA.

The ruling also shows the importance of the IRA custodian. In this ruling it was key that the custodial document said the default distribution method was the beneficiary’s life expectancy. If the document said the default was the five-year option, the IRS might very well have forced distributions over five years.

In the past we have stressed the importance of checking the documents and policies of the custodian. An IRA custodian does not have to allow as much freedom as IRS regulations do. The custodian can impose additional restrictions or charge fees for taking permissible actions. The owner needs to examine the custodian’s policies as part of the estate plan.