Inheriting an IRA: First Things First
You've just inherited a traditional IRA. Now that there are new rules in place, what should you do? How long may you postpone withdrawals to defer tax and let the account keep growing? When you finally begin withdrawals, how long can you stretch them out, and how do you calculate them? These are vital questions, given that about a third of all households have IRAs.
Here are the most common questions and answers:
Q: What's the first step to take if you inherit an IRA? Why?A: The first thing you've got to look for is to see if you truly are the beneficiary. You've got to find the beneficiary form. And, contrary to popular belief, this is not done in a will. I mean, it could be, but that would be the worst-case scenario. Because if [the IRA passes according to the terms of the deceased IRA owner's] will, that means that the estate was really the beneficiary, and that's probably the poorest choice of beneficiary, because an estate has no life expectancy. If there is no paperwork, and the IRA was just left to the estate, then you [as beneficiary] won't be able to stretch out withdrawals over your own life.
But there is a safety provision in the new rules that won't force you to withdraw the whole amount as you had to under the old rules. Under the new rules, you can still continue [withdrawals] over the IRA owner's remaining life expectancy.
Q: Under the old rules, if the IRA went to the deceased owner's estate, it had to be withdrawn how soon?A: Well, there are two rules. Under the first rule, if the IRA owner died before the required beginning date, and there was no designated beneficiary say just the estate, for example then you'd have to withdraw it under what we call the five-year rule, which is by the end of the fifth year following the year of death. That's still the rule today.
Q: What's the 'required beginning date'?A: It's April 1st of the year following the year that you turn 70½ years old. [That's the point at which you must start withdrawing at least a minimum amount annually from your traditional IRA.]
Q: What's the other rule for an IRA that passes through the owner's estate, instead of directly to the beneficiary outside probate?A: That other rule…[says that] if the owner dies after the required beginning date and you don't have a beneficiary form, or the estate's the beneficiary, under the new rules you can withdraw it over the remaining single-life expectancy of the IRA owner.
Under the old rules [in that situation], it would generally all have to come out in the year after the year of death, and that wouldbe it. So that was a big penalty for people with didn't plan properly.
Q: Suppose you've inherited an IRA and you are the named, or designated, beneficiary as listed on the IRA's official beneficiary form. In other words, suppose the IRA goes directly to you, and not through the estate.A: Then you, as the beneficiary, simply look up your age [in official government tables, in IRS Publication 590]. Use the age you turn on your birthday in the year after the IRA owner's death [to help figure the amount of each withdrawal].
So let's say the IRA owner died last year. This year, you - as the designated beneficiary turn 45 years old. Look at the single-life table [in IRS Publication 590. Find your age in the table, and the factor that corresponds to your age. In this case, the factor is 37.7 years.]
That's your life expectancy. It doesn't mean you have to stretch withdrawals over 37.7 years; it just means that's the longest period you can extend distributions over. You can always take more out each year if you want.
[To calculate the amount of your first year's withdrawal, you divide the account balance as of Dec. 31 of the prior year by 37.7.] For each subsequent year, you just reduce the factor by 1 …[and make another calculation].
Q: Does it matter whether the IRA owner died before or after his or her required beginning date?A: No, not if you're named the beneficiary.
Q: Does it matter if, as the beneficiary, you're the IRA owner's spouse?A: A spouse has special rules. The spouse has this thing called a "spousal rollover," which means it entitles the spouse to roll [the inherited IRA] over and treat it as his or her own IRA. Which is usually a great deal and probably the best move, but they don't have to roll over. Q: By treating the account as her own IRA, she and I'm assuming the surviving spouse is a woman doesn't have to begin withdrawing from the account until her required beginning date?A: Right, because now she's the owner. Once she rolls over [her spouse's IRA], she's considered the IRA owner, as if she's the one who put every dime in. It's her account. The age of the IRA owner no longer makes any difference; it's her account once she treats it as her own and rolls it over.
Q: What then?A: Now she's subject to the regular 70½ rules. Then she should immediately name beneficiaries. This is a mistake people make, and I understand it, because of the grieving period. But you should almost do the rollover and name beneficiaries before the funeral.
I mean, I hate to sound so callous, but there's a case now I'm writing up in my …newsletter where the spouse didn't get a chance to complete the rollover. The spouse died, and the IRS is not permitting the executor [of the estate] to finish the rollover, and the kids won't get the stretch-out.
Q: What if she's already past her required beginning date?A: Well, then she rolls over and she starts distributions [withdrawals] in the following year, [based] on her own age [using] the new table. [This table is also in IRS Publication 590. It's the Minimum Distribution Incidental Benefit table.]
Q: Should the spouse always do a rollover?A: There are some cases where a spouse may not want to roll over. See, the spouse has the best options. It's almost like the queen in chess: you can move anywhere if you're a spouse… So instead of doing a rollover, the spouse can remain a beneficiary of the account. Q: Why would a spouse stay as a beneficiary of the IRA if she could roll it over?A: The biggest reason would be a young spouse, one who's under 59½. Let's say the IRA owner dies early, and let's say [the spouse] is young 30 or 40 years… If she rolls over [the account], and now it's her own IRA, and now she wants to withdraw from the IRA, she's under 59½ she'll get hit with a 10-percent penalty [for early withdrawals].
A beneficiary, on the other hand any beneficiary is never subject to a 10-percent penalty [for making a withdrawal from the inherited IRA]. That's one of the exceptions from the 10-percent penalty: death.
Q: If that young spouse, as the beneficiary, begins making withdrawals, she would use the single-life table [to calculate the minimum amount of each withdrawal]?A: Right. She uses the single-life table, but there's a difference. Any other beneficiary but the spouse [must use the minus- one method for calculating withdrawals. In other words, any other beneficiary must find the factor in the life expectancy tables, then subtract 1 from that factor every year to help calculate the amount of each withdrawal].
The spouse gets to go back and recalculate each year, and use a different [factor from the table, one that corresponds to her actual age each year. This can reduce the size of each withdrawal.]
If the IRA owner died before his required beginning date, however, and she doesn't need the money, she can hold off making withdrawals until he would have been 70½ years old to withdraw… You have to look at it in each case; a spouse has a number of options.
Q: What about a non-spouse beneficiary?A: A non-spouse can never roll over… With a beneficiary who's not a spouse, like a child [of the deceased owner], this is where mistakes can be made…
A child can't roll it over to his own IRA. If he does that, it's a fully taxable distribution, as if he's withdrawn it. End of story, end of IRA.
And that's a common mistake. They figure, "Well, I'm the beneficiary, can't I just put it in my own IRA?" No. If you do that, that's a fully taxable distribution.
Instead, the account must be maintained as a beneficiary account for the rest of the beneficiary's life. And the deceased IRA owner's name must remain on the account forever and the IRA must be maintained as what we call and inherited IRA or a beneficiary IRA; you can make it your own if you're a non-spouse [beneficiary].
Q: So what you should do is have the IRA renamed.A: Yes, retitled… There's no official format, but here's all the items you have to get in, what I usually recommend. [For example], Joe Smith IRA (deceased 6-21-01), FBO Jose Smith Jr., beneficiary. (FBO means For the Benefit Of.)
This way you have everything you need in there. You've identified it as a beneficiary account, you have Joe Smith Jr.'s name on it. And it would have Joe Smith Jr.'s Social Security number on it, because he's going to pay tax [on the withdrawals]… Joe Smith St.'s name must stay on the account forever, because it has to be identified as an inherited IRA.
Q: So the IRA is special.A: Right. Beneficiaries have to know that, in the administration of the estate, whoever's dealing with it whether it's you, and executor, an attorney, an accountant they have to have their antennas up that the IRA is a special asset. It has to be handled sensitively, with kid gloves. You can't just change the title to the beneficiaries like you do on other assets that are inherited.
Q: Suppose the non-spouse beneficiary wants to change the investments in the account?A: You are still in control of all the investments. Just because it's maintained as an inherited IRA doesn't mean you can't change [the investments].
Q: But what if you want to change trustees go from bank to broker, for example?A: You cannot just pull the money out and walk it over to the new institution, because that would be a rollover, and as I just said, a non-spouse beneficiary cannot roll over.
Q: So how do you do it?A: Something we call a trustee-to-trustee transfer. You have to get both institutions involved, both banks, both brokers, whoever it is.
Some [trustees] can give you a little bit of a hard time, but there are rulings out there from the IRS saying that there is no question that the beneficiary is entitled to more [the IRA] through a trustee-to-trustee transfer.
So Bank A would move the money directly to Broker B or Mutual Fund B or wherever he wants to move it. But…it has to go from one institution to the other without you touching the money in between.
Q: Let's get to the non-spouse beneficiary's requirement for withdrawals. Does it matter whether the IRA owner died before or after his required beginning date?A: Not if [you, as the beneficiary, are] the named beneficiary, or designated beneficiary. In that case, it doesn't matter if the IRA owner died before or after his required beginning date. You, as the named beneficiary, get to stretch your required distributions over your remaining single-life expectancy. You measure it in the year after death and subtract one [for each year thereafter].
Q: What if you are a non-spouse beneficiary and there's more than one beneficiary?A: Under the old rules, if there were multiple beneficiaries on one IRA, the IRS used to say you had to use the age of the oldest [to calculate the amount of each required withdrawal].
Not any more. Under the new rules, you can each use your own life expectancy based on your own ages, as long as there's a clear indication of who get what . As long as it's clear which child or which beneficiary gets which share, they can each use their own lives… And they'll probably want to separate the accounts and each take their own share, because it'll be easier for them to manage. This way, if one child wants to take out all the money to buy a house, it doesn't affect the other children.
Q: For administration purposes, should the account be retitled?A: It should be retitled, but each one of their accounts will keep the deceased IRA owner's name on it. So they will all begin with "Joe Smith, IRA, deceased…for benefit of [the beneficiary's name]." Q: If someone inherits an IRA, should they see an accountant or lawyer or some other professional?A: Even though these rules did a great job in simplifying things, it's still not that simple…and there's a lot of money involved…so speak to someone who's familiar with the rules.
Here are the most common questions and answers:
Q: What's the first step to take if you inherit an IRA? Why?A: The first thing you've got to look for is to see if you truly are the beneficiary. You've got to find the beneficiary form. And, contrary to popular belief, this is not done in a will. I mean, it could be, but that would be the worst-case scenario. Because if [the IRA passes according to the terms of the deceased IRA owner's] will, that means that the estate was really the beneficiary, and that's probably the poorest choice of beneficiary, because an estate has no life expectancy. If there is no paperwork, and the IRA was just left to the estate, then you [as beneficiary] won't be able to stretch out withdrawals over your own life.
But there is a safety provision in the new rules that won't force you to withdraw the whole amount as you had to under the old rules. Under the new rules, you can still continue [withdrawals] over the IRA owner's remaining life expectancy.
Q: Under the old rules, if the IRA went to the deceased owner's estate, it had to be withdrawn how soon?A: Well, there are two rules. Under the first rule, if the IRA owner died before the required beginning date, and there was no designated beneficiary say just the estate, for example then you'd have to withdraw it under what we call the five-year rule, which is by the end of the fifth year following the year of death. That's still the rule today.
Q: What's the 'required beginning date'?A: It's April 1st of the year following the year that you turn 70½ years old. [That's the point at which you must start withdrawing at least a minimum amount annually from your traditional IRA.]
Q: What's the other rule for an IRA that passes through the owner's estate, instead of directly to the beneficiary outside probate?A: That other rule…[says that] if the owner dies after the required beginning date and you don't have a beneficiary form, or the estate's the beneficiary, under the new rules you can withdraw it over the remaining single-life expectancy of the IRA owner.
Under the old rules [in that situation], it would generally all have to come out in the year after the year of death, and that wouldbe it. So that was a big penalty for people with didn't plan properly.
Q: Suppose you've inherited an IRA and you are the named, or designated, beneficiary as listed on the IRA's official beneficiary form. In other words, suppose the IRA goes directly to you, and not through the estate.A: Then you, as the beneficiary, simply look up your age [in official government tables, in IRS Publication 590]. Use the age you turn on your birthday in the year after the IRA owner's death [to help figure the amount of each withdrawal].
So let's say the IRA owner died last year. This year, you - as the designated beneficiary turn 45 years old. Look at the single-life table [in IRS Publication 590. Find your age in the table, and the factor that corresponds to your age. In this case, the factor is 37.7 years.]
That's your life expectancy. It doesn't mean you have to stretch withdrawals over 37.7 years; it just means that's the longest period you can extend distributions over. You can always take more out each year if you want.
[To calculate the amount of your first year's withdrawal, you divide the account balance as of Dec. 31 of the prior year by 37.7.] For each subsequent year, you just reduce the factor by 1 …[and make another calculation].
Q: Does it matter whether the IRA owner died before or after his or her required beginning date?A: No, not if you're named the beneficiary.
Q: Does it matter if, as the beneficiary, you're the IRA owner's spouse?A: A spouse has special rules. The spouse has this thing called a "spousal rollover," which means it entitles the spouse to roll [the inherited IRA] over and treat it as his or her own IRA. Which is usually a great deal and probably the best move, but they don't have to roll over. Q: By treating the account as her own IRA, she and I'm assuming the surviving spouse is a woman doesn't have to begin withdrawing from the account until her required beginning date?A: Right, because now she's the owner. Once she rolls over [her spouse's IRA], she's considered the IRA owner, as if she's the one who put every dime in. It's her account. The age of the IRA owner no longer makes any difference; it's her account once she treats it as her own and rolls it over.
Q: What then?A: Now she's subject to the regular 70½ rules. Then she should immediately name beneficiaries. This is a mistake people make, and I understand it, because of the grieving period. But you should almost do the rollover and name beneficiaries before the funeral.
I mean, I hate to sound so callous, but there's a case now I'm writing up in my …newsletter where the spouse didn't get a chance to complete the rollover. The spouse died, and the IRS is not permitting the executor [of the estate] to finish the rollover, and the kids won't get the stretch-out.
Q: What if she's already past her required beginning date?A: Well, then she rolls over and she starts distributions [withdrawals] in the following year, [based] on her own age [using] the new table. [This table is also in IRS Publication 590. It's the Minimum Distribution Incidental Benefit table.]
Q: Should the spouse always do a rollover?A: There are some cases where a spouse may not want to roll over. See, the spouse has the best options. It's almost like the queen in chess: you can move anywhere if you're a spouse… So instead of doing a rollover, the spouse can remain a beneficiary of the account. Q: Why would a spouse stay as a beneficiary of the IRA if she could roll it over?A: The biggest reason would be a young spouse, one who's under 59½. Let's say the IRA owner dies early, and let's say [the spouse] is young 30 or 40 years… If she rolls over [the account], and now it's her own IRA, and now she wants to withdraw from the IRA, she's under 59½ she'll get hit with a 10-percent penalty [for early withdrawals].
A beneficiary, on the other hand any beneficiary is never subject to a 10-percent penalty [for making a withdrawal from the inherited IRA]. That's one of the exceptions from the 10-percent penalty: death.
Q: If that young spouse, as the beneficiary, begins making withdrawals, she would use the single-life table [to calculate the minimum amount of each withdrawal]?A: Right. She uses the single-life table, but there's a difference. Any other beneficiary but the spouse [must use the minus- one method for calculating withdrawals. In other words, any other beneficiary must find the factor in the life expectancy tables, then subtract 1 from that factor every year to help calculate the amount of each withdrawal].
The spouse gets to go back and recalculate each year, and use a different [factor from the table, one that corresponds to her actual age each year. This can reduce the size of each withdrawal.]
If the IRA owner died before his required beginning date, however, and she doesn't need the money, she can hold off making withdrawals until he would have been 70½ years old to withdraw… You have to look at it in each case; a spouse has a number of options.
Q: What about a non-spouse beneficiary?A: A non-spouse can never roll over… With a beneficiary who's not a spouse, like a child [of the deceased owner], this is where mistakes can be made…
A child can't roll it over to his own IRA. If he does that, it's a fully taxable distribution, as if he's withdrawn it. End of story, end of IRA.
And that's a common mistake. They figure, "Well, I'm the beneficiary, can't I just put it in my own IRA?" No. If you do that, that's a fully taxable distribution.
Instead, the account must be maintained as a beneficiary account for the rest of the beneficiary's life. And the deceased IRA owner's name must remain on the account forever and the IRA must be maintained as what we call and inherited IRA or a beneficiary IRA; you can make it your own if you're a non-spouse [beneficiary].
Q: So what you should do is have the IRA renamed.A: Yes, retitled… There's no official format, but here's all the items you have to get in, what I usually recommend. [For example], Joe Smith IRA (deceased 6-21-01), FBO Jose Smith Jr., beneficiary. (FBO means For the Benefit Of.)
This way you have everything you need in there. You've identified it as a beneficiary account, you have Joe Smith Jr.'s name on it. And it would have Joe Smith Jr.'s Social Security number on it, because he's going to pay tax [on the withdrawals]… Joe Smith St.'s name must stay on the account forever, because it has to be identified as an inherited IRA.
Q: So the IRA is special.A: Right. Beneficiaries have to know that, in the administration of the estate, whoever's dealing with it whether it's you, and executor, an attorney, an accountant they have to have their antennas up that the IRA is a special asset. It has to be handled sensitively, with kid gloves. You can't just change the title to the beneficiaries like you do on other assets that are inherited.
Q: Suppose the non-spouse beneficiary wants to change the investments in the account?A: You are still in control of all the investments. Just because it's maintained as an inherited IRA doesn't mean you can't change [the investments].
Q: But what if you want to change trustees go from bank to broker, for example?A: You cannot just pull the money out and walk it over to the new institution, because that would be a rollover, and as I just said, a non-spouse beneficiary cannot roll over.
Q: So how do you do it?A: Something we call a trustee-to-trustee transfer. You have to get both institutions involved, both banks, both brokers, whoever it is.
Some [trustees] can give you a little bit of a hard time, but there are rulings out there from the IRS saying that there is no question that the beneficiary is entitled to more [the IRA] through a trustee-to-trustee transfer.
So Bank A would move the money directly to Broker B or Mutual Fund B or wherever he wants to move it. But…it has to go from one institution to the other without you touching the money in between.
Q: Let's get to the non-spouse beneficiary's requirement for withdrawals. Does it matter whether the IRA owner died before or after his required beginning date?A: Not if [you, as the beneficiary, are] the named beneficiary, or designated beneficiary. In that case, it doesn't matter if the IRA owner died before or after his required beginning date. You, as the named beneficiary, get to stretch your required distributions over your remaining single-life expectancy. You measure it in the year after death and subtract one [for each year thereafter].
Q: What if you are a non-spouse beneficiary and there's more than one beneficiary?A: Under the old rules, if there were multiple beneficiaries on one IRA, the IRS used to say you had to use the age of the oldest [to calculate the amount of each required withdrawal].
Not any more. Under the new rules, you can each use your own life expectancy based on your own ages, as long as there's a clear indication of who get what . As long as it's clear which child or which beneficiary gets which share, they can each use their own lives… And they'll probably want to separate the accounts and each take their own share, because it'll be easier for them to manage. This way, if one child wants to take out all the money to buy a house, it doesn't affect the other children.
Q: For administration purposes, should the account be retitled?A: It should be retitled, but each one of their accounts will keep the deceased IRA owner's name on it. So they will all begin with "Joe Smith, IRA, deceased…for benefit of [the beneficiary's name]." Q: If someone inherits an IRA, should they see an accountant or lawyer or some other professional?A: Even though these rules did a great job in simplifying things, it's still not that simple…and there's a lot of money involved…so speak to someone who's familiar with the rules.
There are other tax-cutting strategies in addition to those mentioned here. If you would like assistance in selecting tax-saving strategies that make the most sense in your situation, contact us today!