Many of you, being responsible investors, have also been planning for the future. Hopefully you have established a retirement savings account such as an IRA or 401(k). After spending years contributing to these plans and investing wisely, many of you will have sizable accounts that you might leave one day to your heirs. You might also find yourself as the beneficiary of someone else’s plan. There are many important details concerning inheritance of these funds, especially in cases where the beneficiary is not a spouse of the account holder. Through careful planning you can ensure that these accounts continue to grow tax-deferred for many years beyond the death of the original account holder.
The first priority is to make certain that a beneficiary is detailed for each of your plans. Not having a beneficiary listed can preclude your estate from taking advantage of very favorable tax treatment. The beneficiary of an IRA must have a life-expectancy upon which to base minimum annual withdrawals. Without an actual person named, the entire account must be withdrawn, and taxes paid, within five years. (If the deceased had already started to take distribution, the original distribution plan could also stay in effect.)
Kevin Pollock is an attorney with a Masters in Taxation who focuses on estate planning. He stresses the importance of designating beneficiaries properly. “This ensures that your hard-earned money goes where you want it to go. The biggest mistake is made when simple names are used instead of making a formulaic allocation.”
An example of this is if you had two children, Joe (childless) and Jane (with two children of her own). If you list Joe and Jane as beneficiaries, each would receive half of your account. If Jane dies, Joe would receive everything. If your intention is for Jane’s two children to receive her share, your beneficiary designation must be written in such a formulaic way as to convey your true intent.
Even with new rules providing more favorable tax treatment to non-spousal beneficiaries, leaving your retirement accounts to your spouse is still the most simple and advantageous route to take for most people. The spouse can roll the fund over to his or her own IRA or a new IRA, continue to make contributions, and not have to withdrawal the funds until he or she reaches 70 ½.
Things get a little more complicated when you inherit an IRA from someone other than a spouse. The funds cannot be co-mingled with any IRAs you might already have. You must set up an Inherited or Beneficial IRA. It is extremely important that the account is named correctly. Mess up here and the tax consequences could be huge, as in having to pay taxes on the lump sum that year. Ouch! The name of both the deceased and the beneficiary must be on the account, with the more detail the better. An example; “Mary Jones (deceased 3/15/07) Inherited IRA for the benefit of Sally Smith, beneficiary.” It is very important that the transfer of funds be done properly. The check must be made out in the name of the deceased and sent to the institution that will house the Inherited IRA. If the check is made out to the beneficiary, it would be considered a lump sum distribution and taxes would be due. Again, ouch!
Now that the Inherited IRA has been established, the beneficiary must start taking minimum required distributions (MRD). Unlike spouses, who can wait until they reach age 70 ½ to begin withdrawals, the non-spousal heir must begin these distributions by December 31of the year following the account-holder’s death. The distribution will, however, be based on the life expectancy of the beneficiary, no longer the deceased. Younger heirs can withdraw the lower MRD, allowing the principal to continue to grow over their entire lifetime.
There is still the option of taking the lump-sum distribution instead of setting up the Inherited IRA. The funds would then be considered taxable income. This can result in a double-whammy of sorts, as the large sum of taxable money often bumps the beneficiary into a higher tax bracket as well.
A third option of the beneficiary is to give the funds away. This usually occurs when someone doesn’t need the money and they want their younger children to have the money. This is best arranged during the life of the account holder. The fund can be left to the spouse, with the children listed as contingent beneficiaries. If the spouse doesn’t need the money and refuses the bequest, it would then be inherited by the children, who would have to set up Inherited IRAs or take the lump sum. They would have an even longer life expectancy upon which to grow the account balance tax-deferred. There are many more details involved than there is room here, so make certain to consult a tax or estate planning specialist before attempting to set any of this up on your own.
The Pension Protection Act of 2006 provides similar treatment for the inheritance of 401(k)s by non-spouses by permitting your non-spousal heirs to transfer these assets to an IRA. One unforeseen problem is that the Act doesn’t mandate that companies provide this option. Some companies have opted not to make the necessary changes to their policies due to the time and expense it would take. Now is a good time, if you plan on leaving your 401(k) to someone other than your spouse, to check with your company and ensure that your beneficiaries will be allowed to move the funds to an Inherited IRA if they choose.
Some still recommend that you roll your 401(k) into an IRA of your own when you leave a company, which is permitted by all plans. Although the Pension Protection Act now provides better options for non-spousal beneficiaries of a 401(k), an IRA will give you greater investment options and ensure that your heirs can stretch the distributions over their lifetime. The possible negative is if you need to make use of these funds between ages 55 and 59 ½. Taking an early withdrawal from your 401(k) at these ages will not result in a penalty. If you’ve moved the funds into an IRA, you would have to pay a 10% early withdrawal penalty.
Bill Christensen, Vice President Investment Advisors with Fifth Third Bank, reminds us how timing can be critical. “You have until December 31 of the year after the death of the account-holder to create an Inherited IRA and begin taking MRDs. Miss this date and you’re back to a major tax hit, as well as the loss of future growth of those tax-deferred funds.” To preserve all of your inheritance options, it is best to make certain decisions within nine months of the death. The IRS does not take ignorance of the rules, or grief, as an excuse for missed deadlines.
Christensen also stresses that “the issue of retirement fund inheritance will continue to grow in importance. As firms move away from pensions and the uncertainty of social security looms in the future, more of an individual’s net worth will be tied up in IRAs and 401(k)s than in the past.”
Once again, the common recommendation is to consult a tax professional or estate planner not only before taking distributions from an inherited retirement account, but also while setting up your own plans. Make certain the individual is up-to-date on the ever-changing rules related to your qualified plan. There are so many possible mistakes that can be made, resulting in not only major tax consequences, but also the loss of valuable long-term earning potential for either you or your intended heirs.
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August 28th, 2007 at 7:53 am
When there is more than one beneficiary of an IRA, upon the death of the original account owner it is best to establish separate accounts for each beneficiary. This will allow the beneficiaries to draw the money out of the account based upon their individual life expectancies. Otherwise, they will be required to draw the money out based upon the life expectancy of the oldest beneficiary, which is less advantageous.
To facilitate this process an IRA owner can split their IRA into separate accounts for each beneficiary while they are still alive. This makes it a lot easier for their beneficiaries. The only problem is that some custodians will not permit different beneficiaries on different IRAs for the same account owner.