By Randy Neumann
Recently, one of my clients passed away. Her children, who are also clients, came into my office to take care of business. I told them that the rules of the game had changed, to their benefit. In the old days, before 2005 to be specific, (not really that long ago), a non-spouse (I’ll talk about spouses later) beneficiary of an IRA had three choices when dealing with an inherited IRA:
1) You could take the money and pay the tax in the year that the IRA owner died. Assuming that you did not need the money to buy groceries, this did not produce a good outcome. The proceeds were added to your regular income, and you had to pay tax on the inherited money at your highest marginal rate.
2) You could wait five years from the date of death and then withdraw the money. This outcome is better than the first because it allows you to enjoy five years of tax-deferred growth.
3) You could withdraw the money any time between the first and the fifth year and pay the tax at the time of withdrawal.
Then along came the Deficit Reduction Act of 2005, which was signed into law in 2006, and under the new rules, we have much better alternatives. However, to get these benefits, you have to know how to play the game.
First rule: You have to be named the beneficiary of the IRA. If there is no beneficiary form on file, heirs are at the mercy of the IRA custodians’ default policy. Some custodians award the IRA to a living spouse first and then to the deceased’s estate, while others send it directly to the estate. The lesson here is to make sure your IRAs have the proper beneficiaries designated, so they will not get the short end of the stick. To take it a step further, make sure you are named correctly on any IRA of which you are the beneficiary.
Second Rule: Handle the money properly. If this were your own IRA, you could take the money from one custodian and redeposit it with another custodian within the 60 day limit. You cannot do this with an inherited IRA. You can either leave it with the current custodian, and have them name “your” new inherited IRA, “John Smith, deceased, inherited IRA for the benefit of Mary Smith, beneficiary.” Or, you could have one custodian send it to another using a “trustee-to-trustee” transfer naming it as mentioned above.
Now, let’s talk about spouses. Spouses get a better deal than anyone else. They get to treat the inherited IRA as if it were their own. Therefore, they can rollover the IRA under their own name and postpone distributions until they are 70 years old. However, they are subject to the same 10 percent penalty if they withdraw money prior to age 59.
Non-spouses must begin Minimum Required Distributions (MRDs) by December 31 of the year following the original IRA owner’s death. MRDs are not a bad deal. If you are a female age 40, you have a life expectancy of about 80 years, so you can stretch your payments based on 40 years.
Let’s say that you inherited $300,000 and it earned 6 percent in an IRA that you properly rolled over into an inherited IRA as outlined above. If you are 40 years old, you must withdraw 1/40th from the account, which is $7,950 ($318,000/40). If the account continues to earn 6 percent, it will be worth $328,653 the following year. That year, you would be required to take out 1/39th, which is $8,427.
Do you see what is happening here? The account is growing in spite of the annual withdrawals. It is not until older ages that the withdrawals will become greater than the growth. You are preserving wealth for your family through the deferral of income taxes. Additionally, because you can name a beneficiary, the deferral continues when you die. However, please note, the beneficiary cannot use their age for life expectancy when they inherit the IRA, they must continue using yours.
In the trade, these are called S-T-R-E-T-C-H IRAs and you can see why. Additionally, the same rules apply to qualified accounts such as 401(k)s, 403(b)s, 457 plans, et al. However, the same sticky wicket rules apply to rolling over these types of accounts, so be sure to get professional advice prior to completing the transaction.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for the individual. Randy Neumann CFP® is a registered representative with securities and insurance offered through LPL Financial. Member FINRA/SIPC. He can be reached at 12 Route 17N, Suite 115, Paramus, 201-291-9000.