Rules of the Road for Inheriting IRAs

Inheriting IRAs can be a complicated business.

The rules differ significantly depending on the beneficiary designation and on the owner’s date of death relative to the Required Beginning Date (RBD) for required minimum distributions. The RBD is April 1 of the year following the year in which the owner becomes age 70-1/2.

Note that Roth IRAs have separate, simpler rules of their own. This review will deal solely with traditional IRAs and their close "cousins" - rollover, conduit, SEP, SIMPLE, etc. IRAs.

Although a trust may also be a designated beneficiary, we will leave that more-complex topic for another time.

Spouse as Beneficiary - A surviving spouse has several options, including:

• Cash in some or all of the IRA and pay the associated income taxes. Not a good option! The income tax bite can be substantial, and the surviving spouse loses the long-term tax-deferral benefit of the IRA.
• Leave the IRA in the deceased spouse’s name and take required minimum distributions starting the year after the IRA owner’s death. This option might be preferred if money is needed and the surviving spouse is young (under 59-1/2). The IRS Single Life Table is used to determine the required minimum distribution timeframe using a "recalculation" method (account theoretically is never depleted).
• If the spouse is the sole beneficiary, required distributions can be delayed until the year in which the owner would have reached age 70-1/2.
• Roll the IRA over to the surviving spouse’s name and delay taking required minimum distributions until the surviving spouse’s RBD. This option is generally preferred. Here, a much-less-aggressive IRS Uniform Lifetime Table is used to determine the required minimum distribution payout rate. Also, the surviving spouse can ultimately stretch the IRA over the lifetimes of his/her beneficiaries.

Non-Spouse as Beneficiary - A non-spouse beneficiary can:

• Cash in some or all of the IRA and pay the associated income taxes. Again, not a good option.
• Leave the IRA in the deceased owner’s name and begin taking required minimum distributions starting the year after the IRA owner’s death. The IRS Single Life Expectancy table, based on the beneficiary’s age, is used to determine the required minimum distribution timeframe, but the beneficiary must reduce life expectancy by one year when determining each subsequent year’s minimum (account cannot continue indefinitely). If the owner died after his/her RBD and the beneficiary is older than the owner, the beneficiary may take required minimum distributions using the Single Life Table based on the owner’s original remaining life expectancy.
• If the owner died prior to his/her RBD, the beneficiary may also choose to delay distributions, provided the account is fully distributed within 5 years following the year of death.
• A rollover to the beneficiary’s own IRA is not an option for a non-spouse.

Estate as Beneficiary

• The estate may cash in some or all of the IRA.
• If the owner died prior to his/her RBD, the IRA must be fully distributed to the estate within 5 years following the year of death.
• If the owner died after his/her RBD, the IRA can be distributed to the estate starting the year of the IRA owner’s death using the Single Life Table, based on the owner’s original remaining life expectancy.
• The IRA must be fully distributed by the time the estate is closed.

Other Considerations

• Generally, IRA assets are pre-tax and income taxes must be paid on distributions.
• Beneficiaries who inherit IRAs are not required to pay a 10% penalty on distributions made prior to the beneficiary’s age 59-1/2. The same is not true for surviving spouses who roll a deceased spouse’s IRA over to his/her own IRA.
• Multiple heirs can split an inherited IRA into separate IRAs and base the required minimum distributions on their separate ages. Otherwise, minimum withdrawals are based on the life expectancy of the eldest.
• It is prudent to name both primary and contingent beneficiary(ies), enabling the contingent(s) to stretch the IRA over their lifetime(s) and enjoy the continued tax-deferred nature of the account in the event the primary disclaims or predeceases. Naming the estate as beneficiary (or naming none which defaults to the estate) destroys that opportunity.
• Don’t rely on your will. IRAs pass by beneficiary designation, not by will.
• Not all IRA custodians allow all of the above options, even though federal law does. If yours does not, consider changing.

It’s hard to believe that Congress made substantial simplifications to the IRA rules a few years ago. They used to be much more complicated! Don’t even think of trying to go it alone. Be sure to consult with a trusted financial planner and estate attorney to help you optimize your IRA inheritance planning.

James Terwilliger, Certified Financial Planner™, is Vice President, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext 50630 or by email at jterwilliger@cnbank.com.