If you thought high school physics and calculus were tough, consider the rules for inherited Individual Retirement Accounts (IRA). Deciphering the rules for beneficiaries can be tough and mistakes may be costly in the form of higher taxes and possibly lower investment returns. What do you need to know to avoid common mistakes? Read on.
First, let’s clear up what we’re talking about. An inherited IRA is one which you are entitled to receive as the named beneficiary of another person’s retirement account.
If you’re the spouse, then you’ll have fewer things to contend with since you can take the amount you inherit and roll it into your own IRA.
The complications arise when we’re dealing with beneficiaries other than the spouse. This may include siblings, children, that nice boy down the street who mowed your lawn or a Trust.
For these types of beneficiaries, you’re going to have to follow very specific rules and timetables for distributing the balance and paying taxes accordingly. And like anything else to do with taxes, it’s complicated.
For the trio of middle-aged siblings and an elderly step-dad confined to an assisted living facility, handling the $2 million in retirement accounts they inherited was a daunting enough task before it was complicated by the effect of beneficiary changes put in place before their mom’s death last year.
Mistake #1: Transfer the money. Too often, unsuspecting beneficiaries run afoul of the tax man and owe taxes unnecessarily because they mistakenly believe that they can take out the money and redeposit it within 60 days. Unlike the rule that allows an owner of an IRA to do just that, this is not an option for inherited IRAs.
Mistake #2: Listing the wrong beneficiaries. This is a legal process and governed by laws and paperwork to CYA – yours, the estate of the original owner and the IRA custodian. Too often, folks will not recheck these and assume that the beneficiaries that are listed are correct. But sometimes, when funds are transferred, an IRA owner may not have completed the forms or may have had missing information. Thinking that they would come back “manana” to fix and update this, it goes unnoticed until it’s too late to make changes. If there ever has been a divorce, you should have had the beneficiary changed but there have been plenty of cases where this wasn’t done leaving a long-divorced spouse with all of your assets which was probably not intended.
Mistake #3: Not exercising the 401k. Stretching exercises are a good thing and for IRAs they’re a great way to save money on taxes. What do I mean? Funds left within an employer’s 401k plan are subject to be paid out to non-spouse beneficiaries in five years. For a million dollar IRA, that may mean a non-spouse getting paid out $200,000 a year for five years. This will likely result in putting the beneficiary into a whole different tax bracket and paying more money in taxes. But by rolling the 401k proceeds into an inherited IRA, the beneficiary may be able to buy more time for the distributions as they may be paid out over a longer life expectancy than five years resulting in lower income and lower taxes owed.
Mistake #4: Not understanding the spouse’s options. Spouses have special rights in most things and it is no different with inherited IRAs. Unlike other inheritors, the spouse may transfer the funds into his or her own IRA and not have to start taking distributions until reaching age 70 1/2. Of course there’s always a catch, and in this case the inheriting spouse may have to pay a 10% early withdrawal penalty if taking the money from his or her own IRA before reaching age 59 1/2. It may make sense to set up a different IRA specifically as the inherited IRA and avoid commingling with other IRA funds just to avoid problems.
Mistake #5: Not checking the calender and messing up distributions. Beneficiaries must make sure that before anything else that the owner has received his minimum required distribution for the year of death. No, the deceased is probably not likely to need it but the IRS sure wants to make sure that the highest amount is paid out and taxed. After that non-spouse beneficiaries need to be mindful of the special way distributions are calculated. Unlike for your own IRA, you need to take the balance as of the previous December 31 and divide it by your life expectancy using the IRS “single life expectancy” table. This may be found in IRS Publication 590. In subsequent years, you need to use the same life expectancy but minus a year.
We’ll go into the special issues posed by using a Trust as an IRA’s beneficiary next.
OK. Now wouldn’t you rather be dealing with equations for vectors, force and energy transfer?
You could take a couple of aspirin and call a professional to help you out with this. I do have a name of someone in mind if you’re interested.