Whether you’re inheriting an IRA or aiming to protect your own heirs, you’ve got to learn to dance the IRS jig. Under normal circumstances, barring qualification for an exemption, a distribution from a regular IRA prior to age 59.5 will result in the distribution being taxed to the owner as current income and being subject to a 10% penalty. At age 70.5, required minimum distributions must start. The deadline is April 1st of the year following the year in which the IRA owner turns 70.5. Required minimum distributions consist of the account balance at the end of the previous year divided by the owner’s life expectancy on a chart provided by the IRS.
After an IRA owner dies, there are three major factors that determine how the IRA is treated:
- Inheritances by spouses are treated differently than inheritances by others.
- IRAs that have already commenced distributions are treated differently than IRAs that have not commenced distributions.
- Traditional IRAs are treated differently than Roth IRAs.
If you inherit an IRA from someone other than a spouse, you can cash in the IRA and take the assets. You will then be responsible to pay income tax on the distributed assets as part of your current income. No 10% penalty applies because the reason for the distribution is the IRA owner’s death.*
A non-spouse may not treat an inherited IRA as his or her own or defer distributions from the IRA or make additional contributions to the inherited IRA. However, a non-spouse can maintain an inherited IRA account and will then be required to immediately commence withdrawing annual distributions based on his or her own life expectancy.
Example: Harry, age 60 and Mary, age 24 (common scenario here in Miami I might add) were in “love” but did not marry. When Harry died, he left his $300,000 IRA to Mary. Mary can keep the inherited IRA account but must commence distributions immediately, based on her own life expectancy, even though she is not yet 59.5 years old. The annual distributions are not subject to the 10% early withdrawal penalty, but they are taxed as ordinary income to Mary in the year of distribution. Because Mary is only 24 years old and has a life expectancy of about 59 years (based on the IRS Guidelines), she can distribute the $300,000 over her life expectancy with about $5,084 per year. In this manner, she can stretch the duration of the tax-deferral feature of the inherited IRA, hence the term “stretch” IRA. The younger the beneficiary, the longer the stretch of the tax-deferral period and the greater the tax-deferred growth of the IRA assets.
I hope it goes without saying that the beneficiary form on file with the custodian of an IRA controls both who inherits it and its ability to be stretched out. Many people are unaware that their Will cannot modify an existing beneficiary designation form. If that form doesn’t name beneficiaries or names the estate, the opportunity for a stretch IRA will be wasted. If the beneficiary designation form names a trust, that trust needs to be drafted to enable specific beneficiaries to fully stretch out the tax-deferral options and should also provide the trustee with sufficient notices, instructions, and authority so that it is carried out in the required time.
If people other than a spouse are named as heirs, they must begin taking distributions from the account by Dec. 31 of the year after inheriting, but they can draw these out over their own expected life spans, enjoying decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.
By contrast, if an estate is named as beneficiary, tax deferral is cut short. If it’s a Roth IRA, all funds must be withdrawn within five years. For a large IRA, that might push the beneficiary into a higher tax bracket. However, that would not be a problem for Roth IRAs because there is no tax upon distribution. For a traditional IRA the same rule applies unless the former owner was already 70 1/2–the age at which a traditional IRA owner must begin cashing out. In that case, the distribution rate for the heir is based on the age of the person who died.
What if there’s no beneficiary form on file, you ask? Heirs are at the mercy of the IRA custodian’s default policy. In my experience, Vanguard and Ameriprise award an IRA first to a living spouse and then to the estate and Merrill sends it straight to the estate.
A surviving spouse who inherits an IRA from a deceased spouse has all of the options available to a non-spouse, plus some additional options. The surviving spouse can take an immediate distribution of the IRA and pay taxes currently or choose to be treated as a beneficiary and take distributions based on his or her own life expectancy.
However, a surviving spouse can also choose to be treated as an IRA owner. If the deceased spouse had already turned 70.5 and had commenced taking required minimum distributions, the surviving spouse will then continue to take annual distributions based on his or her own life expectancy. If the deceased spouse had not yet commenced taking distributions, the surviving spouse can then wait until he or she turns 70.5 to commence taking distributions. If a surviving spouse inherits a Roth IRA, distributions need not commence at all.
Remember: Distributions from an inherited Roth IRA are generally tax free, unless the IRA was established less than five years prior to death, in which case the earning on the IRA contributions would be subject to taxation.
Employer 401(k) plans are different – By federal law the money in a 401(k) goes to a spouse, unless he or she has signed a form waiving rights to it. But some employer plans will allow the funds to go straight to the kids if no spouse is living and no beneficiary form is on file. On the other hand, employers usually won’t let non-spouse beneficiaries stretch out 401(k) withdrawals.
*Note: If the deceased owner had already turned 70.5 prior to death and failed to take a required minimum distribution prior to December 31 of the year of death, the estate will need to take the distribution to avoid a 50% penalty.