An estimated 43 million taxpayers have Individual Retirement Accounts (IRAs) with a reported fair market value of about $5 trillion, according to a U.S. Government Accountability Office report. The owner of the IRA is required to take distributions from his or her account beginning in the year that they turn age 70 ½. But what happens to the assets in the IRA if the owner dies? The answer depends on the beneficiary’s relationship to the original owner of the IRA.
Most often, married individuals will name their spouses as beneficiaries of their IRAs. This option gives spouses the most control over the funds with the least amount of financial consequences. Spouses who inherit an IRA generally choose to conduct a spousal rollover and move the money into their existing IRA. When the rollover is complete, the inherited funds are subject to the same guidelines as the spouse’s own retirement assets.
A second option for the spouse is to create a beneficiary (decedent) IRA, which would provide more flexible withdrawal options. A beneficiary IRA remains in the deceased spouse’s name, and the living spouse can choose to take withdrawals without paying the early withdrawal fee. The living spouse can also complete a spousal rollover or use the funds to create an IRA in their name at a later date.
All other beneficiaries
Non-spouse beneficiaries face more limitations in what they can do with the money in the IRA they inherit. For instance, the IRS does not make any concession for a non-spouse beneficiary to roll assets from an inherited IRA into their own account. The beneficiary must contact the financial institution that holds the IRA and request that they rename the IRA to identify them as the beneficiary. For instance, an IRA owned by John Doe and inherited by his daughter, Jane Doe, would be retitled, “Jane Doe, beneficiary of the John Doe IRA.”
Once the account ownership is established in the beneficiary’s name, that individual will choose how to take distributions. It is important to take your required distributions, as the tax penalty for failing to do so is 50% of the value of the required distribution for that year. For instance, if the required minimum distribution this year on your inherited IRA is $10,000 and you fail to withdraw the money, you will pay a $5,000 fine to the IRS. In general, beneficiaries have two options for taking distributions.
- The 5-year rule: If the account owner died after the date he or she would have been required to begin taking distributions (April 1 of the year following the year in which they attain age 70 ½) the beneficiary can choose to liquidate the assets using a 5-year rule agreement. Beneficiaries who choose this option must have all the assets distributed from the IRA by the end of the fifth year.
- The stretch rule: This option allows beneficiaries to stretch the money by taking minimum distributions over the course of their lifetime. The distribution amounts will be determined using the IRS life expectancy table. This method not only preserves the assets over the longer term but also allows the tax burden of the distributions to be spread out over multiple years. Beneficiaries who want to follow this model will need to qualify as a designated beneficiary in order to benefit from this model. This status is automatic for anyone who is named as a beneficiary by the account’s original owner.
One important thing to keep in mind when assuming control of an inherited IRA: Beneficiaries must take any required minimum distributions that are still due in the year of the original account holder’s death. In the case of multiple beneficiaries, there’s no stipulation on which beneficiary must fulfill the required minimum distribution that year, which creates tax planning opportunities that will not be available in subsequent years. For instance, the beneficiary with the lower tax liability may choose to take the distribution, which could equal a larger benefit for all the heirs that year.
And one final reminder about inheriting IRAs: Be sure that your IRA beneficiary form is up-to-date. This is especially important for anyone who has been through a life change, such as marriage, the birth of a baby, divorce or the death of a spouse.