Inherited IRA rules and regulations are unforgiving. An inherited IRA mistake reduces the distribution possibilities, resulting in potentially adverse tax consequences. When done correctly, however, an inherited IRA can provide years of additional income with the ability to spread and reduce tax liability over the long term.
The rest of the inherited IRA story
After the last blog post, Have You Inherited an IRA? It’s Time To Compare Your Options, I quickly realized the need to address the inherited IRA rules and regulations. The questions generated, especially the “how to…” and “what about…” varieties, have been outstanding. Please keep ’em coming! Knowing the options available to beneficiaries of an IRA and which one best suits your needs are just part of the story.
What’s the point of spending time and energy analyzing an inherited IRA strategy if you do it incorrectly? Here are 7 inherited IRA rules that could sabotage your strategy:
1. No Beneficiary
This rule is for the original owner of the IRA (or any qualified retirement plan, for that matter). If an IRA doesn’t have a named beneficiary, the beneficiary defaults to the account owner’s estate, even if you’re the spouse. When that happens, you cannot use your own life expectancy to calculate required distributions.
If the IRA owner passed before April 1, the required beginning date (RBD) of the year after they turned 72, you must distribute the entire IRA within five years. If they died after the April 1 RBD, you could stretch distributions over the ACCOUNT OWNER’S remaining life expectancy.
The only hope you may have is if the IRA custodian has language in its agreement that indicates who inherits the IRA when there is no named beneficiary. Don’t rely on that possibility, though. That’s the exception to the rule. Ensure you have an UPDATED designated primary AND contingent beneficiary for each account and that they are on file with the plan administrator. Otherwise, your heir’s options may be limited.
2. Don’t Forget the Original Owner’s Required Minimum Distribution (RMD)!
If an IRA owner dies after reaching age 73 but before April 1 of the following year, there is no required minimum distribution for the original owner.
However, if the IRA owner died after the April 1 required beginning date, an RMD is required. Check to see if he or she took their RMD. If they did, no additional RMD is needed. If they didn’t, then you, as the IRA beneficiary, must take that RMD by 12/31 of the year the original account holder died.
The RMD will be taxable income for the IRA beneficiary in the year received. If the beneficiary does not take the RMD, they are subject to a 25% penalty or 10% if they take the amount they were supposed to take within two years.
RMDs and RBDs can be confusing, but not something you want to mess up.
3. Inherited IRA Account Title
Unless you’re a spouse who chooses to Treat It As Your Own, the deceased owner’s name must appear in the inherited IRA title and the beneficiary designation.
If John Doe passes away leaving his IRA to his daughter Jane Doe, the account should be titled something like, “John Doe (deceased June 2019) Inherited IRA FBO of Jane Doe, Beneficiary.” The deceased owner’s name and the words “inherited IRA” or “beneficiary” must be in there.
4. Contribution Rules
If you’re the spousal beneficiary and Treat It As Your Own, you’re allowed to contribute to the IRA (as long as you meet all other qualifications) because, technically, it is no longer an inherited IRA. It’s just a plain old IRA that’s yours.
Also, if you, the spouse, are the sole primary beneficiary of an IRA and contribute to the inherited IRA, including rollover contributions, or you don’t take the required distribution for a year as a beneficiary of the IRA, the IRA will be considered Treated As Your Own.
However, you cannot, under any circumstance, contribute to an inherited IRA if you’re either a non-spouse or spouse if there are multiple beneficiaries of the IRA. If you do so, even by mistake, it voids the inherited IRA. You cannot correct it, so don’t think everything will be okay by taking the money back out. Once deposited, even if it’s only 25 cents, a complete distribution of the entire inherited IRA is required, and if it’s a traditional IRA, the total amount is taxable.
5. Transferring Funds
If you do not transfer the inherited IRA correctly, it will result in a deemed distribution, and the entire amount will be immediately taxable (if it’s a traditional IRA). Through a trustee-to-trustee transfer, the IRA must go directly from the deceased owner’s IRA to the correctly-titled inherited IRA.
However, a surviving spouse also qualifies for the 60-day rollover, which allows you to have the funds paid directly to you, and then you may deposit them into a new IRA. So if a spouse is going to move the inherited IRA to their own IRA, they can move it over in this manner.
Non-spouses do not qualify for the 60-day rollover. My advice is to always do a trustee-to-trustee transfer in all instances. There is less chance of a mix-up.
6. Charitable Beneficiary
No income tax is payable when the charity receives the IRA as a beneficiary. That’s the simple part. Potential problems arise when both a charity and an individual are primary beneficiaries. In this case, the charity must be paid its portion by September 30 of the year following the owner’s death. If not, a distribution of the entire balance of the IRA must occur within five years. The spouse cannot create a Stretch IRA, and the other designated beneficiaries lose the 10-year distribution option.
If you want to name charities and individuals as the primary beneficiaries of an IRA, make two IRAs – one for the charities and a separate one for the individuals. It allows you to accomplish your philanthropic goals while providing individuals with all the beneficiary options without complications.
7. Multiple Beneficiaries
When an IRA has multiple beneficiaries, each can typically choose the appropriate inherited IRA option for themselves, i.e., spouse vs. non-spouse. The key is to split the inherited IRA into separate IRAs for each beneficiary by the last day of the year following the year of the original IRA owner’s death.
They can also forego setting up inherited IRAs and share the existing IRA instead. In that case, the oldest beneficiary’s age is used to calculate the distribution amount for ALL beneficiaries. This option is not typical nor recommended.
However, if an IRA has multiple beneficiaries without instructions on dividing it, the shared inherited IRA is the only option. Let’s assume the ages of the beneficiaries of an inherited IRA are 65, 40, and 25, with no instructions on how to divide. The 65-year-old beneficiary’s life expectancy is used to calculate the distributions for all the beneficiaries, which would create a more significant distribution than would be the case for the 40- and 25-year-olds if they had inherited IRAs on their own.
So don’t forget, if you have multiple beneficiaries, designate what percentage each will receive.
Inherited IRA rules – the final word
The first step is to select the appropriate inherited IRA option for your situation and goals. The second step is to ensure you follow the inherited IRA rules and regulations to enjoy the benefits of the first step. This cannot be overstated. Income and tax consequences, not just for you but also for future generations, are on the line.
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