Complexities for Non-Spouse IRA Beneficiaries

Much has been written about assets moving to baby boomer beneficiaries at the death of their parents. If an inheritance involves an Individual Retirement Account (IRA), tax traps abound!

The tax code complicates what should be simple. An IRA bequeathed to a spouse as a named beneficiary is relativity straightforward. But when a non-spouse is a beneficiary, complexities emerge. Ignorance of rules may result in unwelcome taxes or penalties plus forfeiture of the opportunity for ongoing tax-advantaged growth.

Parents or grandparents, regardless of age, need to understand the rules if a primary or contingent beneficiary of any type of retirement plan is a minor or adult child. As advisors we see situations where no beneficiary was designated, an ex-spouse still was named, or the beneficiary was listed as “estate” or a revocable living trust. In each case, complications arise at a time of stress and loss.

If your IRA could pass to a non-spouse primary or contingent beneficiary, your goal is to create a “stretch IRA.” Under “stretch rules” a traditional IRA passed to a child or grandchild does not have to be cashed out and taxes paid. Instead, the IRA can continue to grow and compound, potentially over a long period of time.

As a non-spouse, if you inherit an IRA do not comingle it with any other IRA. It must stand alone as an inherited or beneficiary IRA. You cannot add money to it as you can to an IRA of your own.

Normally, the IRS requires the owner of a traditional IRA to start taking Minimum Required Distributions (MRDs) no later than April 1 following the year in which one turns age 70 ½. Also, distributions taken before age 59 ½ could be subject to a 10% penalty. However, with an inherited traditional IRA, MRD rules apply even if you are under age 70 ½ .

Generally, you have until December 31 of the year following the owner’s death to take your first RMD based on a life expectancy table. For a younger person with a longer life expectancy, the RMD is likely to be less than the growth rate of the assets in the account (depending on the investment policy), hence the ability to “stretch the IRA” over a long period.

Contrary to popular opinion, non-spousal beneficiaries of a Roth IRA (or Roth 401K) are subject to RMD rules, whereas the original owner was not. Rules are confusing. Distributions from a Roth IRA may be subject to taxation if the original account owner did not hold the IRA for a minimum of 5 years. Find out when the Roth IRA was established. There are options and strategies but it is best to consult a tax advisor before making moves.

With a traditional inherited IRA, in addition to a RMD, you may take out additional monies to be taxed as ordinary income free of the pre-59 ½ penalty. With an inherited Roth IRA, you may take money tax-free as long as you are outside of the 5 year rule. This is not wise, however, if you have other sources of money. That applies regardless of the type of IRA. Best to let it continue to grow!

If the original owner passed away before age 70 ½ , before he or she was required to take a RMD from a traditional IRA, you may elect to use the “five year distribution rule.” As long as you withdraw all assets by December 31 of the 5th anniversary of the owner’s death, MRD penalties do not apply. Of course, withdrawals are taxed as ordinary income and you blow the stretch opportunity. If the original owner was older than 70 ½ and subject to RMD rules, you must continue to take RMDs yourself. You may calculate RMDs based on your age or the age of the deceased in his or her year of death. This can be an advantage if the owner was younger than you.

If an IRA is to be split between you and siblings or other persons, separate your portion from the others and complete your RMD by 12/31 of the year following the owner’s passing. If you fail to meet this deadline, the RMD will be based on the oldest beneficiary’s age.

Suppose you are well off and a brother or sister or other beneficiary is in need of funds. You may disclaim and elect not to inherit the assets, in which case your share will be divvied up between the other beneficiaries.

Still confused? Join the crowd. Get advice before taking action!

Lewis Walker is President of Walker Capital Management, LLC. Certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with Walker Capital Management, LLC. lewisw@theinvestmentcoach.com