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New Rules Help IRAs Last For Decades

Last update on: Jun 23 2020
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New rulings from the IRS make it easier to preserve your IRA for a generation or more. Your children and grandchildren can use tax deferral even longer, and IRAs can be customized for each heir.

But you have to take action to benefit from these rulings, and you should leave instructions for your heirs. Otherwise, your IRA is a ticking time bomb that will explode with a heavy tax bill for your heirs.

When an IRA is inherited, the inheritors are required to take distributions from the IRA. Your beneficiary generally can elect to take money out of the IRA either over five years or in equal installments over his or her life expectancy. If the IRA is inherited by a child or grandchild who elects the life expectancy option, the IRA could last for many decades. The growth in the account each year is likely to exceed the required minimum distributions. (The heir is free to withdraw more than the required minimum amount.)

One disadvantage has been that if you had an IRA with several joint beneficiaries, the age of the oldest beneficiary was used to compute the required minimum distributions for everyone. But a new IRS ruling changes that.

In the ruling, the IRA owner was in his 90s. He had inherited an IRA from his wife, which he quickly transferred into eight IRAs in his own name. He designated six primary beneficiaries with equal one-sixth shares. He died a year later. The beneficiaries had the IRA custodian divide the IRAs into six separate accounts, one for each of the beneficiaries. (Not all IRA sponsors will separate an inherited IRA like this.)

The IRS ruled that after the owner died and the beneficiaries promptly had the IRAs separated, each of the beneficiaries could begin taking distributions each year based on his or her life expectancy instead of using the life expectancy of the oldest beneficiary.(Letter Ruling 1999 31049)

This means when a parent and child jointly inherit an IRA, the portion allocated to the child can last much longer than previously. A 20-year-old, for example, can take required distributions over 61.9 years, which could allow the balance to increase by tens of thousands of dollars over the life of the IRA.

This ruling also is the first time the IRS recognized that an inherited IRA can be split into separate IRAs for each of the beneficiaries. Some IRA sponsors have been reluctant to separate an inherited IRA because they were not convinced the IRS would allow it.

In another ruling, the IRS found that an individual who inherits an IRA can name a successor beneficiary of the IRA. When the successor inherits, he can continue to receive payments over the life expectancy schedule the original beneficiary was using. Previously it was believed that the entire IRA had to be paid out to the estate of the first beneficiary at his or her death or at most over the next five years. This ruling has not been published by the IRS yet, but was released to the media by the individuals who received it.

You get the benefits of these rulings and other IRA strategies only if you plan properly and complete the paperwork with your IRA sponsor. The fact is that most IRAs are ticking tax time bombs because the paperwork has not been done.

You cannot effectively name an IRA beneficiary in your will. You must file the IRA beneficiary form with the IRA sponsor. If you don’t name a beneficiary with the IRA sponsor, your estate is the beneficiary and the IRA must be paid out in the year after your death. That means after income and estate taxes your heirs will get about 40% of the IRA.

If you have multiple IRAs, the forms must be filed for each IRA. When you want multiple beneficiaries to be able to form separate IRAs after they inherit, the beneficiary designation should say that each beneficiary is entitled to a separate share of a certain amount. For example, if there are three beneficiaries, say that each is entitled to a one-third share. Otherwise, the IRA sponsor might decide they are to jointly share one IRA.

And provide an alternate beneficiary in case a beneficiary dies before you. Otherwise, the IRA sponsor’s rules decide. Some will have the remaining beneficiaries split up the entire account. Others provide that the deceased’s heirs or estate take his or her share.

The bottom line is not to be afraid to add to the IRA form or to have an attorney prepare a new form.

Keep the beneficiary forms with your will and other key documents. If the fund sponsor lost the forms and you didn’t keep copies, your estate becomes the beneficiary.

You also need to let your beneficiaries know how to handle the inherited IRA or which options to consider.

Many who inherit IRAs don’t realize that when the IRA was subject to estate taxes, the beneficiary can deduct those taxes as a miscellaneous itemized expense. Also, let the beneficiaries know the benefits of continued tax deferral and how they can take advantage of the deferral by scheduling distributions over their life expectancies. Be sure they know how to elect this option. Otherwise, the taxes will be due within five years at the latest.

Until now, most of us have focused on how to build our IRAs. Now, many of us have to focus on the rules for taking money out of the IRAs and preserving them for as long as possible. The rules can get detailed, so it pays to get professional advice to make sure most of your IRA doesn’t end up with the IRS.

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