Excellent tips from the Wall Street Journal on inheriting an IRA. Many retirement investors with qualified funds in IRA’s plan to spend down those funds in retirement. Minimum distribution rules require they be spent each year after 70.5 years of age. But what if it’s left to your heirs? It’s worth reading though this guide to be sure your heirs get what you intend… not an unintended tax hit.
Here is the article:
What’s the best way to handle an inherited IRA?
A recent column about an IRS ruling sparked a slew of reader questions about the mechanics of transferring individual retirement accounts from one generation to another without running afoul of the tax rules.
There is a great deal at stake: Managing an inherited IRA correctly could help enlarge an inheritance. But making a mistake that disqualifies the account from its tax-deferred status could trigger a big tax bill and possibly penalties—and quash its growth potential.
Here are some questions and answers to help families handle their IRA transitions smoothly:
Question: If the IRA owner is over 70½ years old and dies without having taken a distribution for the year, what happens? Does the heir have to take one by Dec. 31? If so, from whose account?
Answer: As you point out, IRA owners must start taking required withdrawals from traditional IRAs by April 1 of the year after they turn 70½. If you are past that age and die before taking the current year’s withdrawal, your IRA beneficiary takes the distribution based on your life expectancy and reports it as ordinary income on his own tax return.
Many IRA custodians require the beneficiary to set up an inherited account and transfer the assets to it before taking the current year’s withdrawal, says Jeffrey Levine, a technical consultant at Ed Slott & Co., an IRA consulting firm in Rockville Centre, N.Y.
Q: What if the IRA owner dies before turning 70½, meaning he didn’t have to start taking required distributions? Is the beneficiary allowed to wait to make a withdrawal until the owner would have turned 70½?
A: If you inherit an IRA from anyone other than your spouse, you either have to empty the IRA within five years of the person’s death or take withdrawals across your life expectancy starting the year after the death, says William Schmidt, an estate-planning attorney at Schmidt & Federico in Boston.
If you inherit an IRA from your spouse, you can either roll it into your own IRA and wait until you turn 70½ to start making withdrawals, or you can set up an inherited IRA. A spouse who has an inherited IRA won’t have to take required distributions until after the deceased spouse would have turned 70½.
Q: My mother passed away in 2003 and left me with an IRA of some $13,000. My accountant has never suggested that I must make withdrawals. What should I do at this point? I am 64.
A: You need to get caught up on your withdrawals right away. Start by withdrawing all of the distributions you should have taken starting with her death through 2011 to avoid a violation for 2011.
Next, file Form 5329 with the Internal Revenue Service for each year you missed a withdrawal, requesting a waiver of the excise tax—50% of the amount you should have withdrawn each year—for the distribution shortfall. The IRS may waive the excise tax if you make it clear that you missed those distributions “due to reasonable error” and that you are taking “reasonable steps” to fix it,” Mr. Schmidt says.
Q: What’s the right way to title an inherited IRA after the first beneficiary dies and leaves it to a new beneficiary?
A: To back up a bit, when you inherit an IRA, it is important to fill out a beneficiary form. Assuming you had done that, the beneficiary you named would need to retitle the account, substituting his or her name for your own.
It is a situation that financial planners are seeing more frequently. Jeff Young, an investment adviser at First Financial Equity in Scottsdale, Ariz., says he first encountered it about 18 months ago.
To retitle the account, the new heir would remove the name of the previous one. If the account were titled “Ann Smith, Deceased (date of death) IRA F/B/O (for benefit of) Barbara Smith, Beneficiary,” and Barbara dies and leaves it to her daughter Carla, it would be titled: “Ann Smith, Deceased (date of death) IRA F/B/O (for benefit of) Carla Smith, Beneficiary.”
One important point: The required minimum distributions would have to continue on the same schedule as before. In other words, you wouldn’t get to recalculate the annual withdrawal amount using the new heir’s life expectancy.
Q: What if the beneficiary has a disability? My friend’s mother died and left him and his sister an IRA of $50,000. My friend isn’t employed and receives a monthly disability check. Someone told him that he could put his share in a regular savings account without any penalty or tax. Is this correct?
A: There would be no penalty for withdrawing the entire IRA, but the money would be counted as taxable income. If an income boost would interfere with your friend’s disability benefits, but he needs the money urgently, he could withdraw half of it from the IRA before Dec. 31 and the rest in January. That way, he could spread the income across two years of tax returns, Mr. Schmidt says.
If the IRA were larger, and required withdrawals would disqualify your friend from receiving benefits, he might consider asking for a private IRS ruling to move the IRA into a special-needs trust without triggering income tax, Mr. Levine says.
The IRS granted permission to a taxpayer to do so earlier this year. But the IRA would have to be worth a substantial amount to make it worthwhile: Hiring a tax expert to ask for such a ruling can cost more than $10,000, on top of the IRS’s $10,000 fee.
Q: If my kids are named as the beneficiaries of my company Roth 401(k) account, would they be able to open an inherited IRA with the funds?
A: Yes, your kids could open separate inherited Roth IRAs and directly transfer their inheritance from your 401(k) to those accounts. They would need to do so by Dec. 31 of the year following the year of your death and take their first distribution that year to make sure they can stretch their withdrawals across their life expectancies.