One of the most common and costly financial mistakes occurs as a result of someone inheriting an IRA or other retirement account and not following the distribution rules. Many IRA beneficiaries don’t even know that there are rules that must be followed. Unfortunately, ignorance of the rules doesn’t reduce the drastic penalties that may occur as a result.
I wish that the IRS rules were simple enough to list in a sentence or two, but they’re not. There’s a reason the IRS calls it the tax code—it has to be deciphered! In the next few paragraphs, I will help you decipher this code in regard to an inherited IRA.
The options that are available to the beneficiaries depend upon two important factors. First, the relationship of the beneficiary to the IRA owner; and second, whether the IRA owner had reached his or her Required Beginning Date (RBD) prior to death.
The relationship factor is divided between spousal, non-spousal human beneficiaries and non-human beneficiaries such as trusts or estates. To further complicate matters, different combinations of the various types of beneficiaries will also change the final distribution options that are available.
Whether the decedent had reached their Required Beginning Date (RBD) also affects the beneficiary’s options. In all situations, while the IRA owner is alive, the RBD for an IRA owner is midnight of April 1 of the year following the year the IRA owner reaches 70-1/2 years of age. If the IRA owner died prior to their RBD, then one set of rules applies, and if they died after their RBD, then another set of rules applies.
The following information will be outlined so that anyone can easily locate the scenario they are looking for. Since there are always exceptions and subtleties, do not use this information to make any final decisions. Seek the advice of a competent professional.
THE FOLLOWING INFORMATION IS APPLICABLE FOR A SPOUSE AS BENEFICIARY:
Regardless of the age of the decedent, the spouse always has two choices as long they are a designated beneficiary and as long as they are the only beneficiary of their portion of the IRA. First, the spouse has the option of treating the IRA as their own if executing a spousal rollover. If this option is elected, then the IRA is treated as if it had been theirs from inception.
The second option the spouse has is to leave the IRA in the name of the decedent. If this option is elected, then the age of the decedent and the spouse both become a factor as outlined below. It should also be noted that if this option is elected, the beneficiary spouse can always elect to do a spousal rollover at a later date if they wish.
Neither the spouse nor the decedent has reached the RBD:
When the beneficiary spouse is either younger or the same age as the decedent, they are not required to take a distribution until the decedent would have reached their RBD. Once the decedent reaches his or her would-have-been RBD, then a distribution will be required based on the age the decedent would have been. It can also be noted that if the spouse is younger than the decedent, they can elect to do a spousal rollover at this time to further delay the distributions.
The spouse has reached the RBD but the decedent has not:
This is the most likely scenario as to why a beneficiary spouse would elect to leave the IRA in the decedent’s name. When the spouse has reached their RBD but the decedent has not, distributions can be avoided until the decedent would have been 70-1/2 by leaving the IRA in the name of the decedent. On the other hand, if the beneficiary was to execute a spousal rollover, they would have to begin taking distributions on or before December 31 of the year following the year of death.
The decedent has reached the RBD but the spouse has not:
This is the most likely scenario in which a beneficiary spouse would elect to execute a spousal rollover. When the decedent has reached their RBD, distributions are required to continue, based on a fixed rate schedule. While an IRA owner is alive, the rate of distribution is recalculated every year based on their age. Upon their demise, however, the rate of distribution becomes fixed based on their age at death. Distributions will be required to be taken in future years by simply subtracting one (1) from the decedent’s would-have-been life expectancy each year.
For example, if the participant was 75 years old at death with a ten-year life expectancy, the next required annual distribution would be 1/10 of the IRA balance. The following distribution will be 1/9 and then 1/8 and so on. Using this method, the IRA will have been fully distributed by the end of the life expectancy that the IRA owner had at death.
By executing a spousal rollover and treating the IRA as their own, the beneficiary spouse will be required to take distributions based on their own age and not the age of the decedent. If the decedent had not taken their distribution for the year in which they passed, then the distribution for that year must still be taken. In future years, however, the spouse can delay distributions until they reach their RBD.
Both the decedent and the spouse have reached their RBD:
In this situation, regardless of the ages of the decedent and the spouse, and regardless of whether a spousal rollover has been executed or not, all future distributions will be based on the life expectancy of the spousal beneficiary. In a nutshell, the IRS treats the spousal beneficiary as if they owned the IRA even if they do not execute a spousal rollover.
THE FOLLOWING INFORMATION IS APPLICABLE FOR A NON-SPOUSE, HUMAN BENEFICIARY:
When a human beneficiary (as opposed to a trust or an estate) inherits an IRA, the only age that matters is the age of the decedent at the time of death. Many IRA beneficiaries are not aware that they need to take distributions from their newly inherited IRA, and such a mistake could be costly. However, there are multiple options, and because these options depend on whether the IRA owner deceased before or after their RBD, I’ve outlined the possibilities below. Keep in mind that the option for an IRA beneficiary to withdraw the entire amount at any time is always available, unless the IRA owner had stipulated otherwise before their demise. All distributions from an IRA will be taxed as ordinary income.
The IRA owner deceased prior to reaching their RBD:
In this scenario, the beneficiaries have two options. First, they can elect to withdraw the entire IRA within five years. They do not need to withdraw any of the funds before the end of the five years but the entire amount must be withdrawn by the end of the fifth year.
Second, the beneficiary can elect to take distributions based on their own life expectancy. For example, if the beneficiary has a 40-year life expectancy based on the appropriate IRS table, they will be required to take 1/40 of the IRA balance the first year, 1/39 the second, 1/38 the third and so on until the IRA is depleted. If this is the desired option, then the beneficiary must take their first distribution by December 31 of the year following the year of death. If the beneficiary fails to take their first distribution by this time, they automatically default into the five-year rule.
If the IRA owner deceased after reaching their RBD:
In this scenario, the same two options that were listed immediately above are still available. However, a third option becomes available when the IRA owner dies after reaching their RBD. This option allows the beneficiary to take the minimum distributions based on the IRA owner’s would-have-been life expectancy. So, if the owner had a 15-year life expectancy, then the beneficiary could take as little as 1/15th of the IRA balance the first year, 1/14 the second, 1/13 the third and so on until the IRA is depleted.
THE FOLLOWING INFORMATION IS APPLICABLE FOR A TRUST AS BENEFICIARY:
This final scenario will examine the required minimum distributions when a trust is the beneficiary of the IRA. Prior to discussing this scenario. It is important to know that there are certain requirements that must be met by the trust in order for these options to be available. To keep this article from becoming a legal guide to drafting a trust, those requirements will not be discussed.
If the trust is the beneficiary and does not meet the basic requirements, the distribution options will once again depend on whether the decedent had reached their RBD before they deceased. If they had not reached their RBD, the only option available is to withdraw the entire IRA by the end of the fifth year. If they had reached their RBD, in addition to being able to withdraw the IRA by the end of the fifth year, the trust can also elect to take distributions based on the IRA owner’s would-have-been life expectancy. For example, if the IRA owner had a 15-year life expectancy at death, the trust can receive 1/15th of the IRA balance the first year, 1/14th the second year, 1/13th the third year and so on.
If the trust does meet the legal requirements, the options listed in the above paragraph are still applicable and a third option also becomes available. Regardless of whether the IRA owner deceased before or after their RBD, the beneficiaries have the option of taking the distributions over their individual life expectancies, should they desire. To take this option, the IRA must be split so that each beneficiary has their own separate account.
If a trust is the beneficiary and the IRA has not been split by September 30 of the year following the year of death, the longest time period that distribution can be taken for will be based on the life expectancy of the oldest beneficiary. For example, if there are three beneficiaries, ages 55, 45 and 40, all three will be required to take distributions based on the life expectancy of the 55-year old. This would be disadvantageous for the 40-year old since the required distributions will be much larger (due to the shorter life expectancy of the 55-year old) than if they were to use their own life expectancy, which would be much longer.
Note that if there are contingent beneficiaries listed in the trust document, their ages will also be considered when determining who the oldest beneficiary is, even if the contingent beneficiary never receives a dime! There doesn’t seem to be much rationale behind this rule, but the IRS has no such rule stating that it has to be rational.
As I mentioned at the beginning of this article, it would be fantastic if the Required Minimum Distributions could be simply explained, but as it may be obvious by now, there is some deciphering that is required. There is much more that could be said on this topic, and this article only outlines some of the more common scenarios. Since there are nuances in every situation, it is not advisable to act on the above information without consulting with a financial planner who is familiar with IRAs.
Finally, should you have a specific question that wasn’t answered in this article, feel free to ask it below in the comment field. Otherwise, if you’re in the mood for a painstaking search through a legal document, check out “IRS Publication 590,” which outlines the rules of IRA accounts: http://www.irs.gov/
