Traditional individual retirement accounts (IRA) are commonplace retirement vehicles, easy to set up and maintain and fairly simple to understand—that is, until the account holder passes away. At that point, the IRA falls into a world of confusing options, deadlines and potentially severe penalties. Here are three “tax traps” to avoid when navigating the complex rules of inherited IRAs.
Trap 1: Not Taking RMDs
If an account holder was older than 70½ at death and hadn’t taken his or her required minimum distribution (RMD) for the year, the beneficiary must withdraw the RMD before year-end or face a possible penalty of 50 percent of the amount that should have been distributed.i
Trap 2: Not Taking Quick Action
Timely action is required of nonspouse beneficiaries who inherit an IRA from an account owner of any age. The following options may be available to nonspouse beneficiaries upon inheriting a traditional and Roth IRA.
- Lump-Sum Distribution
- Five-Year Method
- The beneficiary has five years to distribute the entire IRA asset value. The beneficiary can distribute assets at any time provided the entire value is withdrawn by December 31 of the fifth year after the account holder’s year of death. If a nonspouse beneficiary misses the RMD deadline of December 31 of the year following the decedent’s year of death, the beneficiary will have to either use the five-year method or pay the 50 percent penalty for the unclaimed distribution. Don’t always assume avoiding the penalty is the better option; depending on the numbers, it may be wiser to pay the penalty for one missed RMD rather than empty the account in five years and lose the lifetime of accumulated tax-deferred growth.
- Treat as Beneficiary’s Own IRA
- Available only to a spouse who is the account’s sole beneficiary, the spouse can transfer assets into an existing IRA or set up a new IRA for him or herself.
- Planning Point
- If the spouse treats the IRA as his or her own, the account also is eligible for Roth conversion.ii
- Retitle as Inherited IRA
- The beneficiary transfers assets into an IRA that’s initially set up as—or retitled to be—an inherited IRA. The inherited IRA is treated differently than if it were the beneficiary’s own; for instance, contributions can’t be made to the account. In addition, distributions from an inherited IRA aren’t subject to the 10 percent early withdrawal penalty, regardless of the beneficiary’s age.
If an IRA account names multiple beneficiaries and assets are rolled into one inherited IRA for all, then RMDs are calculated based on the oldest beneficiary’s life expectancy. Setting up separate inherited IRAs for each beneficiary allows RMDs to be calculated based on the sole owner’s life expectancy.
In general, a spousal beneficiary would choose option three to treat the IRA as his or her own. However, there are two scenarios when retitling the account as an inherited IRA may be a better option:
- A spousal beneficiary who is younger than 59½ and will require the IRA funds for annual support may be subject to the 10 percent early withdrawal penalty on amounts withdrawn until he or she reaches age 59½. In this case, opting to take distributions as the beneficiary of the account may avoid the penalty.
- A surviving spouse is older than the decedent. If the spouse were to treat the IRA as his or her own, he or she would be subject to RMDs earlier, and the distributions would be larger in amount as RMDs increase with age.
Trap 3: No-Designated-Beneficiary Rule
Charities, entities and certain trusts have no life expectancy for purposes of calculating RMDs and thus aren’t considered qualified designated beneficiaries. If even one beneficiary of the IRA isn’t an individual, then the IRA generally falls into the no-designated-beneficiary rule, which doesn’t allow the account’s value to be stretched out over a beneficiary’s lifetime.
IRAs with charitable or entity beneficiaries may be able to avoid the no-designated-beneficiary rule if one of two possible exceptions are met. The first exception is that a separate IRA is set up for each respective beneficiary established by December 31 of the year after the account owner’s year of death. Alternatively, the charity’s entire share of the IRA may be paid out by September 30 in the year after the owner’s year of death.
Contact your trusted BKD advisor with questions or for more information.
i RMDs represent the minimum amount a retirement account owner must withdraw annually beginning at age 70½. If the account holder is still employed, the RMD from an employer-sponsored plan can be delayed until the year in which the account owner retires, unless the account holder owns more than 5 percent of the employer. RMD rules apply to all employer-sponsored retirement plans and IRAs, excluding Roth IRAs, while the owner is alive. The RMD is calculated by dividing the account balance as of the prior December 31 by an IRS-provided life expectancy factor. IRA owners must calculate the RMD for each IRA they own.
ii Depending on whether deductions were taken for past IRA contributions, all or part of the amount converted is taxable in the year of the conversion. Taxpayers should consult their tax advisors before moving forward with a conversion.