Getting Through the Twists and Turns of an Inherited IRA

Last month I entertained you with the riveting topic of the tips and traps of being a surviving spouse who inherits an IRA. This month you are going to learn the tips and traps of inheriting an IRA when you are not the widow or widower. Dillard Leverkuhn, local CPA and partner with the Bryan firm Thompson, Derrig & Craig, PC, has graciously returned to enlighten us on this perplexing topic.

The rules for beneficiaries (surviving non-spouses) are different than for surviving spouses. Beneficiaries cannot convert an inherited IRA to be their own. They cannot be an “owner”. For a non-spouse, once a beneficiary, always a beneficiary. (And that was the last of the simple rules.)

How much does the beneficiary get to withdraw?

When the IRA owner dies in 2012, whatever distribution is taken in the calendar year 2012, it is tied to the deceased owner’s life. When the IRA owner dies after April 1 of the year following the year in which he turned 70.5, the beneficiary gets to choose either the owner’s life or the beneficiary’s life for the withdrawal calculations. If the owner turned 70.5 in November 2011 and lived until April 30, 2012, the withdrawal in 2013 is the beneficiary’s first distribution.

Let’s say the owner turned 70.5 in February 2012 and died March 1, 2012. Since the owner did not live to April 1, 2013 (April 1 of the year following the year in which he turned 70.5), the beneficiary must use the beneficiary’s life expectancy. The beneficiary will use the balance of the inherited IRA as of December 31, 2012 to calculate his 2013 required minimum distribution (RMD), regardless of when he will actually receive it. That balance is divided by a factor found in Table 1 of Appendix C in IRS Publication 590. The factor used by the beneficiary is the factor corresponding to the beneficiary’s age on December 31, 2013. (Table 1 ranges in age from 0 to 111 years old.)

Now let’s say the owner had turned 70.5 in February 2012 and died on May 1, 2013. The beneficiary has the choice of the owner’s life expectancy or the beneficiary’s life expectancy. One factor is tied to the deceased owner’s age as of December 31, 2012 (the year of death) while the other factor is tied to the beneficiary’s age on December 31, 2013.

If the deceased owner was older than the beneficiary at December 31, 2012, there is no logical reason for the beneficiary to choose the deceased owner’s age for the factor. The whole idea here is to stretch out the life of the IRA. Choosing an older age uses a factor that causes the IRA to be depleted sooner. If stretching the IRA is desired, the beneficiary should choose the youngest age to tie to a factor.

The beneficiary only pulls the factor from Table 1 in the first year in which he or she takes a distribution. After that first year, the beneficiary simply subtracts 1 from the factor of the prior year. If the first factor is 25, the next year it will be 24 and the subsequent year the factor will be 23 and so on. Once the beneficiary has the first factor, that factor is the maximum number of years he or she is allowed to take the money out of the inherited IRA. In this example, the IRA must be depleted within 25 or fewer years. The beneficiary can always take out more than the factor allows and thus drain the IRA quicker than the maximum number of years. Each year the beneficiary calculates the minimum amount to withdraw by dividing that year’s factor into the December 31st balance as of the end of the previous year. If you are an owner (as contrasted with being a beneficiary) then you would go to Table 1 every year to pull your factor based on your age on December 31 of that year. (See Part 1 of this article for more information.)

When the deceased owner dies before the required beginning date, the first required minimum distribution (RMD) is due in the year following the owner’s death. However, to no surprise, there is an exception. For example, if the owner dies at age 65 his wife is age 68 at the time, she can choose to wait until her deceased husband would have reached age 70 ½ to begin taking her beneficiary distributions and is also allowed to use Table 1 each year to find her factor to calculate her RMD. I bring up this example to show that the surviving wife can wait until the husband would have turned 70.5 before beginning RMDs. This is only available to the surviving spouse who chooses to be a beneficiary and is not available to a non-spouse beneficiary.

The dreaded (or blessed) 5-year rule

Then there is the five-year rule. When the beneficiary is an individual (as contrasted with a trust or other non-person thing), the five-year rule is allowed. The beneficiary does not have to do anything about the IRA at first. But, if the beneficiary does nothing, the entire balance of the inherited IRA must be taken out by the end of the fifth year after the death. In this situation, year one is the year after the year of death. If the owner dies in 2012, the five-year rule begins in 2013. The beneficiary does not have to take the balance in dribbles over the five years. It can be taken all in one whack in December of the fifth year. This might not be good tax planning, but it is allowed.

What if you are a beneficiary who didn’t read this article? What if you forgot to start taking distributions in the year following the owner’s death? You are facing a 50% penalty. Whew! There is a save. You can use the five-year rule to avoid the hefty penalty. Just withdraw the entire IRA balance at any time before the end of year five and you can avoid the penalty.

What if you, the beneficiary, are a jobless college student needing tuition money? Assuming you have low income, you might be able to liquidate the IRA paying little or no income tax. You could take out different amounts each of the five years in any combination as long as all the money is out by the end of the fifth year. The point here is that you are not stuck with a yearly required minimum distribution amount (RMD). Every situation is different, so seek advice of a competent CPA.

Roth IRAs – little known gotchas

Everyone knows that owners of Roth IRAs do not have to take required minimum distributions (RMDs). Surviving spouses can become the owner of inherited Roths and thus, not have to take RMDs. But non-spouse beneficiaries cannot own an inherited Roth IRA. These people must take RMDs on the inherited Roth IRA. And, oh boy, there is another whammy exception. If the deceased owner had not yet gone through the first five-year period of owning the Roth IRA, the non-spouse beneficiary will pay income tax on part of the RMDs. The details are too voluminous to go into here. Seek the advice of a tax CPA.

There is more … lots more

This is the end of my saga on inherited IRAs. Please do not assume I have covered everything. Goodness! We also have issues about multiple beneficiaries, differing deadlines, issues about IRA trustees not knowing all the facts and how that can hurt you, how this all weaves into estate planning issues and the complex issues of designating your estate or other non-person as your IRA beneficiary (usually a bad idea).

Are we craving tax simplification by now? Not me. I figure that if taxes on inherited IRAs were to be simplified, it would mean more tax levied to the beneficiary on the front end. After all, someone could argue that you should not benefit from someone else’s retirement savings.