Retirement assets represent over 34% of all household financial assets in the U.S., estimates show, with the grand total topping $26 trillion. IRA assets represent over $8 trillion of the sum and are the greatest single share class as well as the fastest growing share of retirement assets, due to the aging population and rollovers of 401(k)s and other retirement plan assets.
Given this trend, the number of issues that arise when IRA owners pass away and leave their plans to loved ones is rising. Many of the mistakes being made with inherited IRAs are impossible to fix, resulting in increased taxes being paid and the premature and unnecessary loss of retirement assets’ tax-deferral benefits.
It is critical that you and your advisers understand how to transition and operate inherited IRAs as they are different and subject to different rules than self-owned IRAs.
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- Make sure the title is correct. Inherited IRAs must be formed using correct titling of the account, unless you are a spouse who combines the inherited IRA with your own. The deceased owner’s name must appear in the inherited IRA title, as well as the beneficiary designation. Sometimes shortcuts are taken with the titling, but it is essential that inherited IRAs are distinguished from non-inherited IRAs and comply with IRS requirements. For example, a correct title would look like this: “Bill Brown (deceased April 2017) Inherited IRA FBO of Tom Brown.” This can get more complicated when the beneficiary is a trust with multiple beneficiaries and the beneficiaries want the greatest stretch period possible. The failure to title an account correctly and operate it as an inherited IRA can result in the loss of deferral and potentially accelerated taxation of the account value.
- Be careful transferring the funds. The failure to properly transfer assets to the inherited IRA can also result in the immediate taxation of the IRA account value. Inherited IRA assets must transfer directly from the deceased owner’s IRA to the properly titled inherited IRA, typically as a trustee-to-trustee transfer. Inherited IRAs do not qualify for beneficiary rollover treatment, where the beneficiary has a 60-day window once a year to roll over plan assets. This is allowed only for owner IRAs, not inherited ones.
- Mind the rules. One reason why it is critical to properly title an inherited IRA is that they are subject to strict operating rules. If, by mistake, an inherited IRA accepts a contribution by its beneficiary who intended to make the contribution to his own IRA, it could result in the immediate termination of the inherited IRA and a deemed distribution of all the plan assets as a taxable distribution. A $1,000 contribution made by mistake to an inherited IRA vs. the owner’s own IRA would result in a $500,000 inherited IRA becoming fully taxable!
- Be ready for RMDs. RMDs on an inherited IRA generally begin in the year after the owner’s year of death. If an IRA owner died in March of 2017, the first RMD for the inherited IRA would start in 2018. Many people inheriting an IRA assume that the account RMDs would not start until they reach age 70½, but that is not true for inherited IRA accounts. Only a spouse has the option of merging the inherited IRA into his or her own IRA and thus delay the RMD until their required beginning date.
- Know that RMD rules are different. Inherited IRA required minimum distributions (RMDs) are not always the same as owner IRA required distributions. Inherited IRA RMDs do not qualify for direct charitable contributions (qualified charitable distributions, or QCDs) unless the inherited IRA beneficiary is 70½ or older.
- Understand how to stretch. One of the main current benefits of an inherited IRA is the ability the beneficiary has to stretch out the inherited IRA distributions, hopefully over their life expectancy, to maximize the pretax buildup of the account value. Only named designated beneficiaries can take advantage of stretch benefits. Generally, if a beneficiary obtains the IRA via settlement or directly from the estate without being named as a beneficiary, they do not qualify for the greatest deferral. Furthermore, if an IRA is left as one without dividing it between multiple heirs, the RMDs would be based on the eldest beneficiary’s life expectancy rather than each separate beneficiary’s life. Thus, if an IRA was left to the deceased still-living 70-year-old sibling and two 10-year-old children and it is not divided by the September after the year of death, the annual RMDs would be based on the eldest living beneficiary’s life expectancy, and the children would lose years of potential tax deferral.
- Settle up quickly. Often an IRA is left to multiple parties, some of whom are people and some that are entities, such as a charity. If by the Sept. 30 after the year of the owner’s death the non-person charity is not paid out and the account split, the entire balance of the account must be distributed within five years and no further stretch is allowed.
- Do some tax planning. Be sure to consider tax planning as often it makes sense for a primary beneficiary who is older to disclaim (not accept) an IRA and leave it to the named contingent beneficiaries who are much younger and would benefit for a much longer deferral period based on their longer life expectancies.
It is critical when a loved one passes away and you have the potential of inheriting an IRA that you ensure everything is done in a thoughtful and diligent manner so as to avoid negative tax issues.
PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This commentary is a matter of opinion and is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of Telemus Capital, LLC. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable, but not guaranteed.
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