A Gift That Keeps On Giving

11599866_sChristmas is around the corner. Many of us have spent the last week frantically trying to find Black Friday and Cyber Monday deals to be able to give our loved ones as much as we possibly can. After all, if we can find a good deal on one thing, we may be able to give them more than we originally intended.
Although I fall victim to that same reasoning, I am always amused by how much time is spent trying to find those deals. Don’t get me wrong; I love a bargain. But I often think that if people were to spend as much time verifying the information on their IRA beneficiary forms as they do on their Christmas shopping, their loved ones could potentially receive “gifts” for many, many years to come. How? By making sure that their beneficiaries can “stretch” their Inherited IRAs.
Let me explain. Generally, the owner of a Traditional IRA need only take the required minimum distribution (RMD) from the IRA each year. An Inherited IRA, if transferred correctly, allows a beneficiary to use his or her presumably longer life expectancy, rather than the life expectancy of the original owner, to minimize the required distribution, thereby “stretching” the tax advantages of such an account for many years.
So, by taking just a little bit of time to understand the rules of Inherited IRAs and setting things up correctly, you can give a gift to your loved ones that keeps on giving.
Let’s begin with the basics. You must fill out the beneficiary form on your IRA. If you have no designated beneficiary, a financial institution will follow its own rules to determine how that account will be distributed upon your death. Occasionally, the default distribution will be to a surviving spouse. Sometimes, a custodian will transfer an IRA to the deceased owner’s children if there is no surviving spouse. But often, the account will be distributed to the deceased’s estate. Since an estate is not considered a person for IRS distribution purposes, no alternate longer life expectancy can be used for RMDs. When the estate is the default beneficiary of a Traditional IRA and the owner dies before his or her required distribution beginning date (age 70½), then the distributions from that IRA must be taken either in one lump sum, or over a maximum of five years. If the Traditional IRA owner dies after the required beginning date, then the distributions from that IRA must be taken either in one lump sum or over the deceased owner’s remaining life expectancy (using the IRS Single Life Table). (I know—how can there be a life expectancy if the person is already dead?) Although Roth IRAs generally do not have required minimum distributions, Inherited Roth IRAs do and if a Roth IRA is transferred to an estate, then distributions must be taken in one lump sum or over a maximum five-year deferral. With any of these scenarios, the ability to “stretch distributions” over a younger beneficiary’s life expectancy is lost.
On the other hand, by naming a beneficiary for your IRA, you can ensure that a surviving spouse or any other “designated beneficiary” will receive the account, and if transferred correctly, can “stretch” the IRA. Furthermore, if you name both primary and contingent beneficiaries, a primary beneficiary is given the opportunity to “disclaim” the account and allow it to pass to the contingent beneficiary, who is often even younger. By naming contingent beneficiaries, you can also avoid the problems discussed above that would otherwise occur if your primary beneficiary predeceases you, and no other beneficiary is designated.
In addition to completing any IRA beneficiary forms, it is important to seek the guidance of an estate planning attorney who can guide your beneficiaries and explain how they should accept the IRA upon your death. A surviving spouse can either own the account as a beneficiary, or roll the assets from a deceased spouse’s IRA into his or her own IRA. Doing so would allow the surviving spouse of a Traditional IRA to defer taking a distribution until the surviving spouse reaches that critical age of 70½, when he or she must begin taking required minimum distributions, rather than by December 31 of the year following the original owner’s death. (However, if the surviving spouse touches that money before age 59½, then just as with any other IRA money, the surviving spouse will face a 10 percent penalty for withdrawing early.)
If the beneficiary of an IRA is anyone other than a surviving spouse, then the Inherited IRA cannot be combined with any other IRAs owned by the beneficiary. They must remain separate. Furthermore, whether it is a non-spouse beneficiary or a surviving spouse who has decided to take the account as a beneficiary (rather than through a spousal rollover), an Inherited IRA must be classified as such. It must be titled either an “Inherited” or “Beneficiary” IRA and it must include the name of the original owner. If this process is not followed correctly, two issues can arise. First, the inheritance may be classified as an IRA distribution under the rules of the IRS. If deemed a distribution, an heir could potentially owe a substantial amount of income taxes and possibly even penalties on the distribution, as well as penalties for exceeding contribution limits if the “distribution” is directed to another Traditional IRA owned by the beneficiary (unless it is a spousal rollover). Secondly, the multi-year tax shelter that an inherited IRA can provide is lost.
But whether your beneficiary is your spouse, a child, a grandchild, a niece or a nephew, the best thing you can do is for them is to give them direction. Generally, each heir must begin taking distributions from an Inherited IRA by December 31 of the year after the original owner’s death. But tell them not to touch the money until they know exactly how the rules affect them. For example, many Traditional IRA owners know that they can transfer money from one IRA into another IRA in 60 days or less without penalty, even if they are younger than 59½. However, this same rule does not apply to Inherited IRAs. With Inherited IRAs, a transfer must be performed via custodian to custodian.
Take the time, during this giving season, to make sure your IRA beneficiary designations are done correctly and your beneficiaries have the information they need to accept an Inherited IRA correctly. Doing so will give them a gift that will last for years.
Be vigilant, and stay alert, because you deserve more.