SALEM, OREGON SEPTEMBER 2015 VOL. 11, NO. 9
Let’s Talk: W. Ray Sagner CFP
Informed Decisions on Inherited IRAs
While there have been a couple of articles in this column over the years discussing IRAs, there has been brief coverage on Inherited IRAs. As with most articles that appear in this space, the inspiration often comes from seeing folks that have made decisions in the past without proper guidance or enough information. The following paragraphs will lay out options for IRA beneficiaries - whether it’s one you have chosen, or it’s yourself who is the beneficiary.
Spouses have more flexibility than non-spouse beneficiaries when it comes to inherited IRAs. They can roll the IRA into their own and avoid distributions until they reach 70.5 years old. For surviving spouses that are older than 70.5 and their deceased spouse was younger, they can wait until the deceased would have been 70.5 to take distributions. They can also take all the money out within 5 years, provided the deceased was not taking the required minimum distributions required by the tax code.
Let us back up a step and clarify what the required minimum distribution (RMD) means. The year, in which an IRA owner turns 70.5, they are required to take out a minimum amount per year. The formula is simple but must be accurate -- the balance of the account on December 31st divided by life expectancy according to Internal Revenue Service tables. The penalty for neglecting the distribution is 50% of the amount required to be taken. If you inherit an IRA, make sure that if the owner was 70.5 or older that the RMD was taken in the current year.
A non-spouse beneficiary has four options: Take a total distribution of the account in the year of death; distribute the account over five years or by the fifth year; continue the RMD of the deceased provided they were receiving it at the time of death; or roll the account into an Inherited IRA. When rolling the account over the new account must be titled correctly. When you inherit an IRA, you should retitle the account so it reads like this: "William Smith, Deceased (date of death) IRA F/B/O (for benefit of) James Smith, Beneficiary." Unfortunately, some advisors or institutions make mistakes, so you should read any documents carefully and ask questions if you are unsure of what something means.
The first option is not recommended for most people, for the entire amount will be taxed and included in your taxable income. The second option is similar -- spreading the distribution over five years will depend on your situation and your need to forestall taxes. The third option, which continues the RMD of the deceased, may be a viable option for some depending on age and the balance of the account; however, if the previous owner was along in years, the distributions could be large and few. The fourth option, taking the account over the beneficiary’s life time, is one of the best planning options for most folks.
The best thing about leaving an IRA to the next generation or even skipping a generation is that the account has the potential to continue to grow tax-deferred over the longer life span of the beneficiary. This type of strategy is often referred to as a stretch IRA. Another great benefit of an inherited IRA is that you can have access to the money before age 59.5. Most withdrawals from traditional IRAs before that age carry a 10 percent penalty, but this is not so with an inherited IRA.
As the owner of an IRA, when considering beneficiaries it is generally not a good idea to make your Living Trust the beneficiary unless special consideration is given. A trust has no life expectancy and therefore the account will be distributed and tax will be due.
An inherited IRA is centered at the three-way intersection of estate planning, financial planning and tax planning. With do-overs granted exclusively by Internal Revenue Service, one wrong decision can lead to expensive consequences. As with most financial issues, it is important to seek the advice of a Financial Planner before acting upon important decisions.