Large portions of our savings are landing in IRAs. Be aware that rules of thumb for IRAs do not work with inherited IRAs. In fact, commonly held beliefs are frequently the wrong thing for an heir to do. In the current economic environment, I see many people embracing the do-it-yourself ethic for their tax, divorce and financial dilemmas. Once in a while that will work, but more often than not, it will be bad news. Making the right decisions with an inherited IRA is the riskiest and potentially the most financially devastating DIY project I have come across. I have asked Dillard Leverkuhn, local CPA and partner with the Bryan firm Thompson, Derrig & Craig, PC, to come back and explain this brain teaser to us. Thank you, Dillard.
The first thing to know about inherited IRAs is that your usual vocabulary gets tossed out the window. A widow may think she is a surviving spouse, but for the IRS, she must officially choose to be one instead of a beneficiary. In addition, she may think she owns the IRA her husband left to her, but she must officially announce herself as an “owner”. So, pay close attention to the labels described here.
Surviving spouses have different rules than surviving non-spouses (beneficiaries).
If the IRA owner (decedent) dies in the year in which he turns (or would turn) age 70½ or any year after that, we must take his required minimum distribution (RMD) in the year of death. Yes, even if he did not take it that year while he was alive. If he dies on any day between January 1 and December 31, the RMD must be taken in that year. Our fine legislators didn’t consider situations where the IRA owner dies so close to year-end that there is insufficient time to deal with an RMD in the year of death. The rule is written to be a “too bad, so sad” situation. There is one glimmer of hope. Tax CPAs know how to write a letter to the IRS begging forgiveness from the 50% penalty that comes from not taking the RMD when required. No guarantees the IRS will forgive, but it is worth a try.
If you are the surviving spouse and the sole beneficiary, you can choose to make the IRA your own. You may notify the IRA trustee (usually brokerage or bank) to either change the account name to yours or roll it over into your existing IRA. If you are the surviving spouse and younger than age 70½, rolling it over could be a good idea because you can postpone distributions. You will use a different IRS distribution table than will non-spouse heirs (beneficiaries). Your distributions can be smaller, thus stretching out that IRA if necessary. If you are the surviving spouse and age 70½ or more, you may want to convert the IRA to yours. Now you become the owner, and by the IRS tables you can take out even less each year than can a beneficiary (who, by the way, is not an owner). This is even greater stretching.
Beneficiary versus Surviving Spouse?
You may think that in normal speak you are both a beneficiary and a surviving spouse. Normal people like you and me would agree, but not the IRS. You have to pick one. You cannot be both.
According to the US Census Bureau, there are many widows younger than age 59½. Let’s say you are tragically a widow at age 55 and you need to tap that IRA to pay bills. If you become an owner, you would have to pay 10% penalty to get those funds. But if you are considered a beneficiary (who is not an owner), you do not pay the 10% penalty when you get that money out. Death is an exception to the penalty. You need a CPA to calculate which is your best bet: be an owner and pay the 10% penalty or be a beneficiary and avoid the penalty. Trust me, this is not a slam-dunk calculation.
If you are a surviving spouse who is older than age 70½ and are older than your deceased spouse was at death, (and he or she was younger than age 70½ at death) you may not want to own that IRA. Why? Because as an owner, you would need to immediately start taking distributions (less stretching). If you choose to be a beneficiary (not an owner), you can stretch the IRA by waiting until the year in which your deceased spouse would have turned age 70½ to start taking distributions.
Spouses can choose to be a beneficiary (which is not an owner). If you decide to be a beneficiary instead of an owner, your first three rules to understand are …
You cannot later become an owner of the inherited IRA.
You cannot contribute to the inherited IRA.
You cannot rollover the balances of the inherited IRA into another IRA.
But remember, only a surviving spouse who was the sole beneficiary can choose to be either an owner or a beneficiary, but not both for the same IRA. A non-spouse cannot be an owner but can be a beneficiary. As a beneficiary, you can move your share of the inherited IRA to another trustee as long as you do two things.
Move it in a trustee-to-trustee transfer
Title the IRA as “Deceased name, deceased, for the benefit of you, beneficiary”. Such as “Cedric Stewart, deceased, for the benefit of Tracy Stewart, beneficiary”.
Scary Warning: If I give my inherited IRA a different name than described in #2 above, the IRS will call it a full distribution. If this is a $1 million IRA and I am younger than 59½, I will have to pay income taxes and 10% penalty on that entire $1 million. If I am older than 59½, I will have to pay income taxes but not the penalty. Plus, I have lost the ability to stretch the IRA over my lifetime. Not pretty.
Another Scary Warning: Although non-inherited IRA owners are allowed to clean out an IRA and move it into another IRA within 60 days without incurring taxes or penalties, this is not true of inherited IRAs of which I am the beneficiary. My inherited IRA must be transferred “trustee to trustee” or the IRS will tax it. Again, not pretty
Have your eyes glazed over yet? Mine have. And we are not done yet. Let’s take a break and finish this up in the next column. Besides, my editor limits the amount of space I get.