Planning for Heirs and Your IRAs

Most people have done only part of their essential IRA planning. You aren’t done planning until you’ve ensured the IRA’s beneficiaries have the information and tools they need to maximize the IRA’s after-tax value. The primary goal of the IRA, of course, is to maintain your standard of living in retirement. A secondary goal is for the IRA to outlast you and improve the standard of living of your loved ones.

Inherited IRAs face some complicated little-known rules that create pitfalls. Too often, IRA beneficiaries don’t know the rules or don’t understand the long-term power of an inherited IRA. They take actions that cause a high percentage of the IRA to be drained away in unnecessary taxes. Your loved ones need to be aware of key rules and strategies if they order to maximize the value of your IRA. The IRA custodian doesn’t represent your beneficiary. Some have knowledgeable IRA specialists who can provide valuable information. But the custodian is not there to give advice to your beneficiary or make recommendations. Your heirs need another source of advice.

You first should understand the financial needs and goals of your heirs. Would they want to maximize the tax deferral of the IRA or empty and spend the IRA fairly rapidly after inheriting it? When they want or need to spend the money, you won’t need to do much planning. This discussion is for when heirs want to maximize, or at least preserve the option of maximizing, the deferral of an inherited IRA. Here’s what heirs need to know.

Take a breath. There’s no reason to make quick decisions. The tax law doesn’t require major actions until October of the year after the year of the original owner’s passing. When the owner passed away in June 2010, for example, decisions don’t have to be finalized until October 2011. Once actions are taken they tend to be locked in, so decisions shouldn’t be rushed.

Proving beneficiaries. The beneficiary designation form on file with the IRA custodian determines who inherits the IRA. You should keep the designation up to date and also keep a copy of the latest form readily available to both your executor and the beneficiary. With all the changes in financial services firms, there is the potential the sponsor could lose your latest form, so be sure to keep copies.

Don’t take a check. One big difference between an inherited IRA and other IRAs is you can’t defer taxes when you personally roll over money from one IRA to another. With other IRAs you can receive a check and deposit that amount in another IRA within 60 days. Not so with an inherited IRA. All transfers have to be from one trustee to another to defer taxes. Take a check and it will be taxed to you as a distribution.

Owner’s RMD. When the deceased IRA owner was over age 70½, the required minimum distribution for the year of death must be taken by the estate.

Spouses are special. When a spouse is the sole primary beneficiary of an IRA, he or she has a special right. The spouse can roll over the inherited IRA to an IRA in his or her own name. It can be either an existing IRA or one set up to receive the rollover.

The spousal rollover allows a fresh start. None of the characteristics of the original IRA carry over. The spouse does not have to base distributions on the original IRA owner’s schedule. The spouse names new beneficiaries and takes distributions based on his or her age without reference to the inherited IRA. In other words, the rolled over IRA is treated the same as an original IRA of the spouse. The spousal rollover must occur by the end of the year after the year in which the owner passed away.

There are few cases when a spouse who is sole primary beneficiary wouldn’t want to do a spousal rollover. One case is when the inheriting spouse is under age 59½ and needs distributions to pay living expenses. If the spouse rolls over the IRA to a new IRA, the 10% early distribution penalty will apply to distributions in addition to income taxes. But the 10% distribution penalty won’t apply to distributions from an inherited IRA.

 On the other hand, an IRA owner who wants to control who eventually receives the residual IRA may not want to name the spouse as sole primary beneficiary. The inheriting spouse’s ability to do the rollover means the original owner loses control over who eventually inherits the residual amount.

Designated beneficiary. A key figure of an inherited IRA is the Designated Beneficiary. This is the person whose life expectancy is used to compute required minimum distributions. This person must be selected from the named beneficiaries and contingent beneficiaries, and the IRA custodian notified of the choice by Sept. 30 of the year after the original IRA owner died.

The IRA title. Legal technicalities make a big difference. An IRA beneficiary (other than a spouse) doesn’t want to put the IRA into his or her own name or roll it over to a new or existing IRA in his own name. When any of those actions is taken, the entire IRA must be distributed and included in gross income within five years.

To preserve deferral, the ownership title of the IRA must indicate it is an inherited IRA and contain three items: the name of the original owner who died; the word “IRA”; and an indication it is “for the benefit of” the beneficiary. An appropriate title is “Max Profits IRA (deceased), F/B/O Hi Profits, beneficiary.

Splitting the IRA. An IRA could have multiple primary beneficiaries, such as when you name your adult children as equal beneficiaries. They could continue the IRA as one. They would have to agree on how the IRA is invested and how distributions above the required minimums would be determined. Also, the age of the oldest beneficiary would determine the distribution schedule.

But the beneficiaries have the right to split the IRA tax free into a separate inherited IRA for each of the beneficiaries. Each beneficiary would choose his or her own investment strategy and distribution policy. The beneficiaries should know they have that right. They could decide splitting the IRA would make things easier and preserve family harmony. You should confirm with the IRA custodian it will allow the split and any fees it would charge.

Required distributions. Beneficiaries who prefer to use the IRA’s tax deferral face limits. Annual required minimum distributions are imposed. The amount of the RMDs depends on whether or not the original owner was already taking RMDs. In either case, the beneficiary has two options for computing the RMDs.

When the original owner was not over age 70½ and hadn’t begun RMDs, one option is for the beneficiary is to compute annual distributions using the beneficiary’s life expectancy. The second option is to distribute 100% of the inherited IRA to the beneficiary by the end of the fifth year following the year of the original owner’s death. Under the second option the distributions can be taken in any pattern or schedule the heir wants. For example, the entire amount could be left in the IRA until just before 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 maximize the IRA’s tax deferral, creating a Stretch IRA. The second option is for an heir who doesn’t intend to use the long-term tax deferral. The five-year period gives the beneficiary time to search for ways to reduce income taxes on the distributions.

When the original owner was older than 70½ and had begun required minimum distributions there also are two options. The first choice again is for the distributions to be calculated using the beneficiary’s life expectancy. The second option is to continue the original distribution schedule using what would have been the age and life expectancy of the deceased owner each year.

All of these distribution options apply only when the beneficiary is an individual or a certain type of trust. When an estate or some other non-individual is beneficiary, the IRA must be distributed within five years when the previous owner was not over age 70½ and otherwise over the deceased owner’s life expectancy. If no beneficiary is named, the custodian’s policy controls. Some custodians say a surviving spouse is the beneficiary, and the estate is the beneficiary if there is no spouse. Other custodians say the estate is the beneficiary when there is no designated beneficiary.

Deadlines. An IRA beneficiary is required to take several actions by the end of the year after the year in which the original owner passed away. If the owner died in June 2010, these actions must be taken by Dec. 31, 2011. The first required minimum distribution must be taken by that date. When multiple beneficiaries inherit an IRA and want to split it into separate IRAs, the split must be done by that date. A spouse who wants to roll over the inherited IRA to a personal IRA must do so by the same deadline. The IRA custodian must be notified of the Designated Beneficiary by Sept. 30 of the year after the year in which the original IRA owner passed away. Beneficiaries need to keep the deadline in mind.

No conversions. An inherited traditional IRA can’t be converted into a Roth IRA.

The inheritance deduction. One of the least-known and more confusing deductions in the tax code is for “income in respect of a decedent. It may be available to those who inherit IRAs, annuities, and similar assets.

Suppose Max Profits left a valuable estate that included an IRA and was subject to the federal estate tax. The estate tax accountant computes that the IRA was responsible for 36.7% of the estate tax paid, and that the IRA’s share of the estate tax was $175,000. When the beneficiary takes distributions from the IRA, a miscellaneous itemized deduction (not subject to the 2% floor) of 36.7% of each distribution is allowed. This continues until the beneficiary has deducted a total of $175,000 over the years. To take the deduction the beneficiary must itemized deductions on Schedule A.

The estate tax accountant should determine the data for the deduction. Details can be found in the IRS Publication 559, Survivors, Executors, and Administrators available free on the IRS web site, www.irs.gov.

August 2010. RW