Susan B. Geffen, Esq., M.S.G.2447 Pacific Coast Highway, Second Floor
Hermosa Beach, CA 90254
Offices throughout Los Angeles and Orange County to serve you.
What if you inherited an IRA? Then slightly different rules apply. Spouses can roll over inherited retirement accounts into IRAs in their own names, which simplifies things greatly going forward. However, others are limited to the few additional choices available to any heir: to take a one-time lump sum (could be a huge income tax liability), to withdraw all money from the account within the first five years (again could be a huge income tax liability), or to take withdrawals stretched out over the course of their lifetime.
This last option involves calculating RMD amounts for each year in order to ensure that the heir takes enough money out to satisfy the IRS. How that is calculated for heirs brings me to my next oft asked question. Keep in mind that inheritors of any age must take distributions. In other words, if you're an heir, you don't get to wait until age 70 1/2 with your inherited IRA before you need to start taking RMDs. Also, note that while the original owners of Roth IRAs are generally exempt from required minimum distributions, those who inherit Roth IRA’s must take RMDs in the same way as those who inherit traditional IRAs and other types of retirement accounts. Let’s take 3 scenarios that have often unfolded before my eyes. Remember, the best result is that the inherited IRA distributions get stretch out for as long as possible so that the income tax liability to the beneficiary is minimized. Please note, for an IRA to be stretched out, there must be identifiable beneficiaries. If there are no identifiable beneficiaries, the proceeds must be distributed within 5 years. Scenario 1 The Five-Year Rule An adult child comes into my office after their parent’s death. There was no estate plan, no will and no beneficiary designation on multiple IRAs. Some of the cases in question included situations where Dad died, Mom was the named beneficiary, BUT she died without naming her own beneficiary. Others included Mom as the beneficiary of Dad's account, BUT she predeceased Dad. Sometimes, my client gets lucky and the IRA agreement indicates who is to inherit; each IRA custodian has its own agreement and the default language will provide definitive guidance when there is no beneficiary named on the form or there is no form at all. Sometimes my clients are unlucky, and the IRA agreements all defaulted to the estate of the account owner or the beneficiary. In this type of case, there is no identifiable beneficiary (neither the estate nor a charity is considered living, breathing “identifiable” beneficiaries). Therefore, if you inherit the IRA through the estate, you cannot use your own life expectancy to calculate required distributions. If the IRA owner died before April 1 (his/her required beginning date) of the year after he or she turned 70 ½, you must empty the IRA in five years. If he or she died after the April 1 required beginning date, then you can stretch distributions over the ACCOUNT OWNER'S remaining life expectancy. Under the five-year rule: ? You can withdraw from your inherited IRA assets at any time, in any amount. ? You must withdraw all assets by December 31 of the fifth anniversary year following the IRA owner's death. As long as the account is depleted within this timeframe, the RMD penalties can generally be avoided. However nearly 40% of the savings can be lost to taxes. It is usually always better to be able to stretch an IRA. This Scenario 1 is avoidable. I always counsel my clients to check their beneficiary forms! If they can't be found, simply fill out a new form and send it in. Also, don't just name a primary beneficiary. Name contingent beneficiaries as well. Many times, this simple step will save the stretch IRA. Then take it one step further, make sure your parents or your children or other family members do the same thing for their IRAs. Don't let your retirement funds go down the drain. Scenario 2 The Charity If you are planning to leave an asset to charity after you die, a tax-deferred account can be an excellent one to use. That’s because the charity will pay no income taxes when it receives the money, and the account will not be included in your taxable estate when you die, reducing the amount your family may have to pay in estate taxes. A charity does not qualify for the IRS stretch rules as it is not an induvial person. Furthermore, individual persons can only use the life expectancy method if ALL beneficiaries of the IRA are individuals. If a charity is one of a group of beneficiaries, then all beneficiaries must take a lump sum. There are two ways that the individual could still get the opportunity to stretch out the IRA payments even if a charity is part of a group designation: If the group of beneficiaries’ interests are expressed as fractional or percentage shares, and the beneficiaries establish “separate” accounts for their respective shares in the IRA by December 31 of the year after the year of the IRA owner’s death, then each separate account is treated as a separate IRA for distribution purposes. The obvious drawback of this approach is that the beneficiaries must meet the deadline for establishing a separate account. (This, of course, assumes that the beneficiaries or the professional advisors know that a separate account is necessary and why.) Also, these interests must initially be “expressed as fractional or percentage shares.” The other exception is that a beneficiary is “disregarded” if the beneficiary’s interest in the IRA is completely distributed by September 30 of the year after the year of the participant’s death. Thus, if the charity’s share is paid out before the deadline, the remaining beneficiaries would be entitled to use the life expectancy method. Again, the drawback is that time passes quickly and people miss deadlines, or people are unaware of the problem until it is too late. If making sure that the beneficiaries can use the life expectancy payout method is an important goal, I do not recommend that you make a group designation that includes a charity for a portion. Instead, separate the IRA, and make a separate account that is wholly payable to charity. It's important to separate your shares of the decedent's IRA in your name and then complete your first RMD by December 31 of the year following the original IRA owner's death. If you don't meet this deadline, your RMD calculation will be based on the oldest beneficiary's life expectancy. If that person is older than you are, you will need to take larger RMDs, which will deplete your tax-advantaged assets more quickly. Scenario 3 Naming the Trust as Beneficiary Why would one name their trust as a beneficiary? Why would the owner of an IRA want or need to name a trust, rather than a person, as his or her beneficiary? The primary reason is to exert control over post-death distributions, thus limiting access to an inheritance. This is especially useful if one of your children has creditor issues, is a spendthrift (a person who spends money in an extravagant and irresponsible way) has drug issues, etc. You do not want this individual to have access to the lump sum that he or she may demand. Sometimes I recommend creating a super trust for IRA distributions depending on the amount of money at stake and the issues adult children bring to the table. When naming a trust as beneficiary of an IRA or other retirement asset, it is critical that the trust be recognized as a “qualified trust.” This allows the trustee to stretch out payments from the IRA in a tax-efficient manner, namely over the life expectancy of the oldest beneficiary. If a trust is not a qualified trust, the IRA must be paid out in a tax inefficient manner: within (a) 5 years or (b) the account owner’s remaining life expectancy, depending on whether the account owner died before or after age 70 1/2. For a trust to be qualified, it must, among other requirements, have identifiable beneficiaries, all of whom are individuals. However, determining who the beneficiaries of a trust are for this purpose is not easy. The IRS does not just look at the current beneficiaries. It also looks at contingent beneficiaries; i.e., those who take upon the happening of a contingency, such as the death of a previous beneficiary. At the same time, the regulations purport to draw a distinction between contingent beneficiaries and “successor beneficiaries.” Contingent beneficiaries are considered for purposes of determining whether a trust has identifiable individual beneficiaries; successor beneficiaries are not. The latter term refers to a “person who could become the successor to the interest of one of the [account owner’s] beneficiaries after that beneficiary’s death.” Thus, the line between a contingent beneficiary and a successor beneficiary is blurry at best. Accordingly, it is not clear how far down the beneficial line of succession one must look to determine who the beneficiaries of a trust are for qualified trust purposes. Remainder beneficiaries, contingent beneficiaries, beneficiaries who take in the event of a catastrophe, and eligible beneficiaries under a power of appointment could all be considered. If any of these are not individuals, the trust arguably does not have identifiable individual beneficiaries and thus fails as a qualified trust. Fortunately, all this uncertainty can be avoided by naming as beneficiary a trust with conduit provisions. In a conduit trust, the trustee is required each year, with respect to any retirement plan payable to the trust, to withdraw the minimum required amount and pay it within a reasonable time to the beneficiary or beneficiaries of the trust. Accumulation of payments from the retirement plan within the trust is not allowed. Under this approach, the IRS will not look for identifiable beneficiaries beyond the beneficiaries who are entitled to current distributions and stretch out will be based on the life expectancy of the oldest beneficiary. It is very important to Mark Dec. 31 of the year following the year of the IRA account owner's death on your calendar because you must decide what to do with your inherited IRA on or before this date. Do not ask the IRA custodian for advice as to what you should do with your inheritance, and do not simply withdraw 100 percent of the funds as soon as possible. Slow down, take a deep breath, and consult with an estate planning attorney (like myself), a tax accountant, or a financial advisor to determine which option will work best for you considering your personal situation. If you rush in and make a mistake without expert assistance, it can cost you. For example, all these options depend on trustee-to-trustee transfers. If you take possession of the funds at any point in time before it lands in another IRA account, even accidentally, that money will often be deemed to have been a distribution. You'll be taxed accordingly. You're not permitted a 60-day window of time to reinvest when you're a non-spouse beneficiary. Make sure that any assets transfer directly from one account to another or from one IRA custodian to another. There is no option for a 60-day rollover when a non-spouse beneficiary is inheriting IRA assets. If you receive a check, the money will generally be taxed as ordinary income, and is ineligible to be deposited into an inherited IRA you may own at another firm, or back into the inherited IRA that it was withdrawn from to begin with. Susan