According to the Investment Company Instituteís 2018 Fact Book, Americans have more than $28 trillion in assets in retirement accounts including $9 trillion in IRAs. Consequently, it is not uncommon for a retireeís IRA to be her largest asset apart from the family home, making it highly likely that at some of this tax-deferred wealth will eventually pass to the IRA ownerís children.
Because of the tax rules that govern IRA distributions, parents generally want to be sure that their IRAs are divided among their heirs as they intend without triggering extra taxes. To accomplish this, they need to understand how to properly name account beneficiaries. Children of deceased IRA owners are often concerned about how they can receive these assets without losing a big chunk to Uncle Sam. From their perspective, it is important to know IRS Required Minimum Distribution (RMD) rules and how they must receive their share of these accounts to minimize taxes and take full advantage of the power of tax-deferred investment growth that IRAs can provide.
The good news is that IRAs can pass smoothly to children without probate and without a large, immediate tax burden. The key to this happy result is the account beneficiary form, which gives the financial institution holding the IRA instructions regarding whom the account is to pass to when the original owner dies.
Without a beneficiary form, IRAs become property of the decedentís estate, making it subject to probate and leaving the estateís executor in charge of identifying the proper beneficiaries. When IRAs are left to an estate, beneficiaries lose the opportunity to stretch out the annual RMDs over their own life expectancies. Instead, they must compute RMDs using the decedentís remaining, likely much shorter, life expectancy resulting in significantly larger taxable withdrawals each year.
The executor can still set up separate inherited IRA accounts for each heir when multiple children are named as beneficiaries in the decedentís will, but it is important to follow strict guidelines to avoid triggering a distribution of the entire IRA. The executor must instruct the custodian to establish new IRA accounts titled with the decedentís name such as, ďJane Doe, deceased, IRA for the benefit of John Doe,Ē then fund the new inherited IRA via a direct transfer of his share of the account from the original IRA. If the executor were to withdraw cash from the IRA, then attempt to re-deposit it into the new IRA, the distribution would be immediately taxable since non-spouse IRA beneficiaries cannot use the 60-day rollover rule.
A better result occurs when children and grandchildren are named directly on a beneficiary form. This leaves the estate out of the picture and allows the beneficiaries to take smaller RMDs to minimize the taxable income from the IRA. It is still critical that the original IRA be divided properly by the custodian, by setting up correctly-titled inherited IRAs for each beneficiary and funding them via direct transfers. Beneficiaries must also understand the RMD rules since a missed withdrawal will trigger a 50 percent excise tax on the RMD amount that was not satisfied each year.
For inherited IRAs, required minimum distributions must be taken by the beneficiaries by Dec. 31 of the year after the decedentís death. If the original owner had already begun taking RMDs starting at age 70Ĺ, it is important to check with the IRA custodian as to whether the decedent had taken her RMD prior to her death. If not, this distribution will also need to be satisfied by the beneficiaries. The custodian will have the correct amount calculated already leaving the beneficiaries with the relatively simple task of just requesting their share.
The RMD for the year after death will be calculated separately for each beneficiary using the prior year-end account balance and the IRS Single Life Expectancy Table for his or her age. In subsequent years, this life expectancy factor is simply reduced by 1.
Note that it is also allowable for beneficiaries to delay RMDs for up to five years after the decedentís death. However, this approach requires the entire account balance be withdrawn by Dec. 31 of the fifth year after the decedentís death. In most cases, it will be more desirable from a tax perspective to stretch the required withdrawals over more than five years.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Bearing Point Wealth Partners, Inc., a fiduciary financial planning firm in Hampton. He can be reached at (603) 926-1775 or email@example.com.