Estate Planning for an IRA (Before 2020)
(This Article only applies to IRAs inherited prior to 2020)
Upon inheritance, your surviving spouse can roll your IRA into his/her own IRA account, postponing required minimum distributions - and taxes - until he/she turns 70 ½. Other beneficiaries do not have that option. If you want your beneficiaries (other than your spouse) to continue to benefit from tax-deferred or tax free growth, you must be certain that each beneficiary is a “Designated Beneficiary.” A Designated Beneficiary is an individual, or a trust which meets certain requirements (“qualifying trust”). Each designated beneficiary must directly transfer his/her portion of your IRA into a separate account known as an Inherited IRA, which comes with its own set of rules.
While many spouses name each other as the primary beneficiary, they may overlook the need to name a contingent beneficiary. If there is no beneficiary named, then your estate becomes your beneficiary. That may seem like the simple approach if your children are the beneficiaries of your estate. However, while your children will still inherit your IRA, they will be required to withdraw all funds and close the IRA by the end of the fifth year after your death if you die before you turn 70 ½. If you die after age 70 ½, but have not named a beneficiary, the required payout will be based on your life expectancy, as set by IRS tables. Your life expectancy will be at most 15.3 years. The effect is to accelerate the required payment of income tax on your IRA over a shorter period, or to shorten the period for tax-free accumulation in a Roth IRA.
Naming Designated Beneficiaries as beneficiaries of your IRA (or as contingent beneficiaries, if your spouse is still alive) gives your beneficiaries more flexibility. Once the Designated Beneficiaries transfer your IRA to Inherited IRAs, they can take annual distributions based on their life expectancies. For example, a 50-year-old beneficiary could stretch distributions (and the required income tax payments) over the next 34 years. A 50-year-old beneficiary of a $100,000 IRA would be required to take a distribution (RMD) of approximately $2,900 in the first year. However, if you die at age 75 and leave the IRA to your estate, your beneficiary would be required to withdraw approximately $7,500 as the first-year distribution (RMD). If you die prior to reaching age 70 1/2 and leave the IRA to your estate, your beneficiaries would have to withdraw the entire IRA within 5 years.
To take full advantage of the Inherited IRA, you should advise your beneficiaries to divide your IRA into separate Inherited IRAs for each beneficiary, especially if they differ in age significantly. If your IRA is not divided into separate Inherited IRAs, the age of the oldest beneficiary will be used to calculate the required distributions, which will shorten the number of years that your IRA can grow tax-deferred. Your beneficiaries will have until December 31 of the year after the year of your death to divide your IRA into separate Inherited IRAs for each beneficiary.
Roth IRA distributions to your beneficiaries are usually not taxable income, but your beneficiaries cannot leave the funds in the Roth IRA account forever. The rules for withdrawals from Inherited Roth IRAs are the same as they are for traditional IRAs. If your beneficiaries transfer the money to accounts for Inherited Roth IRAs, they can usually stretch withdrawals over their life expectancies.
Special Rules for Beneficiaries of Inherited IRAs
Your spouse may either transfer your IRA directly into his/her personal IRA, or may transfer your IRA into a separate Inherited IRA. When your beneficiaries transfer funds from your IRA to an Inherited IRA, they must transfer these funds directly. If the beneficiaries receive checks made out to them personally, they will be prohibited from depositing the funds into an Inherited IRA, and will have to pay taxes on the entire amount that is distributed to them. A beneficiary of your IRA does not have a 60-day window to withdraw funds from your IRA and then rollover the withdrawal into a new inherited IRA account. The transfer from your IRA to the Inherited IRA must be direct (custodian to custodian). Once the money is in the Inherited IRA account, your beneficiaries have until December 31 of the year after the year of your death to take their first distribution (RMD). If your beneficiaries do not take the required distributions, they may have to pay a penalty of up to 50% of the amount that they should have withdrawn. Also, if you died after starting the required minimum distributions (RMD) at age 70 ½, but had not yet taken the RMD for the year in which you died, the non-spouse beneficiary must take your RMD in the year that you died.
Your beneficiaries can cash out the account at any time without paying an early withdrawal penalty, even if they are not yet 59 1/2. However, unless they inherit a Roth IRA, they will have to pay income tax on the tax deferred income from the original IRA. A large withdrawal could push the beneficiary into a higher tax bracket. If they take an early distribution from an inherited Roth IRA, they will lose its tax-free advantage.
Taking distributions from an Inherited IRA based on the beneficiary's life expectancy will minimize the income tax due and maximize tax-deferred or tax-free growth. You can find beneficiary life-expectancy tables in IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs) (Note: The life-expectancy factors are different than those used for non-Inherited IRAs.)
Ignoring Non-person Beneficiaries
IRAs with multiple beneficiaries that include a charity or other non-designated beneficiary must pay out that entity's share by September 30 of the year following the owner’s death. If that share is not paid out and the account has not been split, the rest of the beneficiaries cannot take withdrawals over their life expectancies. Your beneficiaries will have to complete all withdrawals from your IRA within five years of your death if you died before your required beginning date for taking distributions (age 70 ½). If you died after your required beginning date, your beneficiaries must take their annual distributions based on your life expectancy.
If a trust is a beneficiary, the trust must be properly drafted to comply with the IRS rules for the trust to be recognized as a designated beneficiary. These rules include the requirement that the trustee send a copy of the trust (or a detailed summary) to the IRA custodian by October 31 of the year following your death. If the trust is not recognized as a designated beneficiary, or other rules are not followed, the trust is considered a non-designated beneficiary and the five-year payout rules discussed above will apply.
The above is a summary of the general rules for IRAs. You should not rely on this advice as each person’s plan requires review for advice that would apply to their situations. Additionally, the rules and laws may change. You should consult with your tax or estate planner on a regular basis for current information and advice.