You work hard to manage your IRAs and set them up just right. One reason is so your heirs will get the maximum benefit from the IRAs. Unfortunately, heirs rarely know what the owner had in mind or what the IRS requires when IRAs are inherited. As a result, the IRS gets thousands of extra dollars in taxes from Inherited IRAs, and heirs benefit from a much smaller portion of those IRAs than they should.
Here are the key points your heirs need to know.
When an IRA is inherited, the beneficiary must begin minimum annual distributions. The heir can choose from two methods for computing the required distributions. (Of course, the beneficiary can take more than the required minimum, including the entire IRA, at any time and pay income taxes.) The choices available depend on whether or not the original owner began required minimum distributions before passing away.
A second general point is that surviving spouses have an option in addition to those set out here. A surviving spouse can roll over the inherited IRA to another IRA in the surviving spouse’s own name. This will be treated as a new IRA of the surviving spouse, and the inherited IRA rules will not apply.
Before covering the distribution options, let’s go over two other rules your heirs need to know. The 10% penalty for distributions before age 59 1/2 does not apply to inherited IRAs. The heirs are required to begin distributions of some amount regardless of age, and the 10% penalty is not a factor.
A second rule is that Roth IRAs have different distribution treatment than traditional IRAs. The original owner of a Roth is not required to take minimum annual distributions. An heir begins taking distributions from Roth IRAs over his or her life expectancy. The rules in this article are for traditional IRAs.
Now, let’s look at the options for heirs.
We’ll start with the case when the original owner was not over age 70 1/2 and had not already started the required minimum distributions.
The first option for the beneficiary is to begin taking at least annual distributions from the IRA using the beneficiary’s life expectancy. These distributions must begin the year after the year of the original owner’s death.
Suppose Max Profits passed away in 2004. His son, Hi, was sole beneficiary of the IRA. Under this option Hi must begin the required distributions by the end of 2005. The distributions are determined by taking the IRA balance on Dec. 31 of the preceding year (2004 for the first required distribution) and dividing it by Hi’s life expectancy factor listed in the IRS’s single-life expectancy table. The table can be found on the members’ web site at www.RetirementWatch.com. If there is more than one beneficiary, they can split the IRA into separate IRAs, and each can compute distributions using his or her own life expectancy. Or they can keep one IRA and base the distributions on the life expectancy of the oldest beneficiary.
The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the year that contains the first anniversary of the original owner’s death. The distributions can be taken on any schedule the heir wants. For example, the entire amount could be left in the IRA until the end of the fifth year. Or roughly equal amounts could be taken each year. Or money could be withdrawn as needed, with whatever is left in the IRA distributed by the end of the fifth year.
The first option is best for an heir who wants to use the IRA’s tax deferral for as long as possible. Remember, an amount exceeding the required minimum distribution can be withdrawn at any time. The second option is for an heir who doesn’t intend to use the long-term tax deferral of the IRA. The five-year period gives the beneficiary some time to search for ways to reduce income taxes on the distributions.
The second case is when the original owner was older than 70 1/2 and had begun required minimum distributions. Again, the beneficiary has two choices, but the second choice is different.
The first choice is for the heir to take annual installments over the beneficiary’s life expectancy, as in the first scenario. The computation and rules are the same.
The second option does not include a five-year rule. Instead, the heir can continue distributions using what would have been the age and life expectancy of the deceased original owner. As under the other option, the IRA balance on the previous Dec. 31 is divided by the life expectancy factor.
The second method is advantageous when the beneficiary is older than the original owner. The IRS says that the second method is the default method if the beneficiary does not make a selection or the IRA custodian does not name the other method as the default. The second method also is the only method available if the IRA owner named the estate as the beneficiary or did not name a beneficiary.
Those are the tax rules, but there might be additional rules to consider. An IRA sponsor can limit the choices further in its IRA documents. The IRA documents might set one method as the default. That means distributions automatically will begin under that method unless the beneficiary selects the other option by the deadline set by the sponsor. In addition, the IRA sponsor could limit the distributions to only one of the methods and not allow the other as an option.
IRA owners should read their documents carefully or ask the IRA custodian about its rules for inherited IRAs.
There are some other general rules to consider.
The deceased might have had several IRAs. The tax law has the owner compute one required minimum distribution for the year based on the combined balance of all IRAs. The owner then has the option of taking required minimum distributions after age 70 1/2 from any one IRA or from more than one IRA in any desired ratio.
Heirs should know that even if the deceased was taking the RMDs from only one IRA, all the inherited IRAs fall under the rules for cases in which the deceased already began RMDs.
Another consideration is the RMD for the year of death. If the RMD was not already taken for that year, the beneficiary must take it and include it in his or her income for that year. If that RMD is not taken, then the 50% penalty will apply unless the IRS chooses to waive it.
Keep in mind that these rules do not apply to non-IRA retirement plans. Employer plans do not have to allow accounts to stretch more than five years. In fact, they can require payouts in “a reasonable time,” which often is one year. Many single-owner Keogh plans require the entire account to be distributed almost immediately after the owner dies.