What you need to know as the beneficiary of someone’s IRA

WHEN SOMEONE NAMES YOU as the beneficiary of their individual retirement account, or IRA, you will find yourself at the intersection of estate planning, financial planning and tax planning. That’s one busy–and confusing–intersection. One wrong decision with that inherited IRA can have costly consequences…and good luck trying to persuade the IRS to give you a do-over!

This month, I’ll try to clear up some of the confusion regarding IRA distributions and options for the inherited IRA.

The worst thing you can do would be to cash out the inherited plan, put the money into your account, then call your agent and ask “now what?” At that point, it’s too late to take advantage of the better options that are available for the special handling of the inherited IRA.

The 5-year option vs. the “stretch” option

The money in an inherited IRA must be taken out eventually, except in cases where the beneficiary is the spouse of the deceased. Non-spouse beneficiaries have two options for liquidating the inherited IRA account. They must either:
(1) liquidate the account within five years of the original owner’s death, or
(2) take distributions over their life expectancy. This is known as the “stretch option,” which leaves the most funds in the IRA for as long as possible. This option also retains the greatest amount of liquidity for the new account owner.

The stretch IRA is the tax equivalent of the “treasure at the end of the rainbow.” Hidden beneath the layers of regulations and layers of red tape is the ability to shelter funds from taxation, allowing those funds to continue to grow for decades.

But, one mistake by the beneficiary or even the original IRA owner before their death, and that little benefit could be lost forever. Instead, the beneficiary will be forced to take the money out of the IRA under the five-year option. Especially for large accounts, that can add up to a massive tax bill for the beneficiary–unless the IRA is a ROTH.

For ROTH IRAs, taxes are paid before the funds go into the decedent’s account. Distributions from an inherited ROTH IRA will be tax-free unless the account was established less than five years before death, in which case the earnings may be subject to taxation.

Special rules for spouse beneficiaries

Whenever someone inherits their spouse’s IRA, they can take their late spouse’s account and treat it as their own IRA. If they don’t need the income, they can let that money continue to grow until age 70 ½. If the surviving spouse elects to take distributions from the traditional IRA before age 59 ½, they could be subject to the 10% IRS early withdrawal penalty. However, if the spouse beneficiary needs the money and is under age 59 ½, they can roll the account over into a beneficiary IRA to avoid the 10% penalty for early withdrawal. Should the spouse inherit a ROTH IRA, distributions will never be required.

Another benefit of rolling over the account into the surviving spouse’s name is that everything resets; the surviving spouse is now able to use the funds as they see fit, and also name their own beneficiary.

Non-spouse beneficiaries must act soon

Non-spouse beneficiaries shouldn’t procrastinate. In order to take the stretch option, a beneficiary must take the required minimum distributions (or RMDs) annually, based on his or her own life expectancy. You must take your first distribution by December 31 of the year following the death of the original IRA owner. If you miss that date, you default back to the 5-year option. Rule of thumb for IRA beneficiaries: Don’t rush to make any decisions, but do be aware that there are time limits to make your decisions.

Be aware of year-of-death RMDs

When it comes to traditional IRAs and RMDs, things can get a bit tricky. To help clarify things, let’s look at one scenario.

Your father passed away in January, leaving you as the beneficiary of his traditional IRA. Dad was over the age of 70 ½. You contact the IRA custodian and learn that your dad did not take his RMD for the year (as most people take the distribution towards the end of the year). Now, since your dad (the IRA’s original owner) did not take the RMD prior to his death, you (the beneficiary) must take it out before the end of the year. If you don’t, you (the beneficiary) are liable for a penalty of 50% of the required amount that was not withdrawn.

This can cause even more grief if someone passes away late in the year. Let’s assume the same scenario as before, but, this time, your father passes away in late December. In this case, you might not even find out about his account until it’s too late to take out that year’s distribution. The deadline for taking out the annual RMD is Dec. 31, so time is of the essence.

However, if your dad was under age 70 ½ when he passed away, or if he had a ROTH IRA, then there would be no year-of-death required distribution.

For more information on the timing of your RMDs, see my article in the February 2018 issue of William Penn Life.

Don’t ignore beneficiary forms

An incomplete or missing beneficiary form can disrupt an entire estate plan. Many members think that their beneficiary designations are current and correct, only to pass away without realizing that was not the case. This can create quite a problem for your heirs and also for the IRA custodian who is trying to do the right thing. If there is no beneficiary on the IRA, or if the primary beneficiary is deceased and there are no contingent beneficiaries, then the account goes to the estate and the ultimate beneficiary will default to the 5-year option for payout. This is why we constantly advise our members to review all of their beneficiary designations on a regular basis.

Trusts as IRA beneficiaries

While it is possible to list a trust as primary beneficiary of your IRA, it is also possible that this designation could go horribly wrong. Done incorrectly, a trust could unknowingly limit the options that are available to your beneficiaries. If the trust provisions are not carefully drafted, the custodian may be forced to use the accelerated payment distribution rules–when that isn’t what you or your beneficiaries desire. The trust needs to be drafted by a legal expert who is experienced with the specific rules for leaving retirement assets via trust.

This month we explored the options available to beneficiaries of inherited IRAs. I hope this helps to clear up some of the confusion regarding these delicate issues.

Maybe it’s time for you to review the beneficiaries on all of your accounts. Now is the perfect time to call your WPA agent or broker to be sure your beneficiaries are up-to-date and your plans are directed as you intend.

Don’t have an agent? Give us a call at the Home Office, and we’ll be glad to help or assign an agent to your account.

Until next time, enjoy the last months of summer!