Does your family have an Uncle Horace?
I invented him for this article but a lot of families have a similar character: a hardworking, frugal soul who lives alone and says little but thinks a lot. This is the kind of person who accumulates a tidy sum. As the saying goes ‘You can’t take it with you’, so when Horace reaches the end of his hopefully long life, it has to go somewhere.
Like almost everything in the IRS code, the rules for Inherited IRAs are tricky. A misstep can result in unnecessary taxes/penalties and missed opportunity for tax deferred growth for the beneficiary(ies).
Read on to learn more!
Michelle Morris, CFP®, EA
BRIO Financial Planning
You just got a call from someone at Staid and Musty Law offices. Uncle Horace named you, his only niece, beneficiary of his substantial traditional Individual Retirement Account (IRA).
Before you do a thing, it’s important to understand the rules. **
Retitle: You must retitle the IRA (unless you choose the lump sum method) indicating that it is inherited and including the original owner’s name, i.e.: Uncle Horace, deceased, inherited IRA for the benefit of Only Niece Name.
RMD: If Uncle Horace was required to take a Required Minimum Distribution (RMD) from his account the year he died but he had not yet taken one, you will be required to take it for him, calculated the same way if he had not died. The executor should be able to guide you on this.
Transfer: If you want to move the money to a different custodian, (i.e. from Fidelity to Vanguard) you must specify a “trustee-to-trustee” transfer. If you take possession of the funds, even for 5 minutes, it is considered a full distribution and you will be taxed on the whole thing.
Distributions: You have 2 (possibly 3) distribution options for taking the money:
- Lump sum
a. With this option, you don’t have to retitle the account, and you take all the money at once. You will be taxed. (Federal and possibly State income tax depending on where you live).
b. This added income may move you to a higher tax bracket depending on the amount of the distribution and your other sources of income. Your tax bill could be painful.
- Life Expectancy Method
a. This is the so-called “stretch” method and it is a beautiful thing as it allows you to continue to defer taxes over your lifetime.
b. You must take a distribution no later than 12/31 of the year after uncle Horace died. In this example we’ll assume Uncle Horace died in 2015, so your first distribution is due by 12/31/16.
c. Your annual distributions are spread over your life expectancy, calculated using your age on your birthday in 2016 (the calendar year following the year Uncle Horace died.)
d. You use the IRS Single Life Expectancy Table to determine your required minimum distribution (RMD). Let’s say you turn 49 years old in 2016 (the year after Horace dies). You look at the table and it says your life expectancy is 35.1 years.
Your RMD will be the balance of the account on 12/31/15 (the year Horace died) divided by 35.1 years. The next year, you do not look at the table again. You subtract 1 from 35.1 which = 34.1.
Your RMD for 2017 is the account balance on 12/31/16 divided by 34.1.
e. You are taxed on each distribution. You can always take MORE than your RMD, Uncle Sam and possibly your state will be delighted to get the tax.
- 5 Year Method (This option only applies if Uncle Horace was under age 70½ at the time of his death.)
a. You have until 12/31 of the 5th year after Uncle Horace died, at which point all assets need to be fully distributed. (So for example, you could take nothing in years 1 through 3, half in year 4 and half in year 5.)
b. You are taxed on each distribution
Beneficiaries: Be sure to name new beneficiaries on the IRA. Now it’s your turn to be the frugal, hardworking, quiet benefactor.
Three important points regarding taxes:
- You will not be subject to a 10% early withdrawal penalty on the distributions from the Inherited IRA, even if you are under age 59½.
- It is important to determine if there are any post-tax dollars in Uncle Horace’s IRA. If there are, then you don’t need to pay tax again on those dollars. The custodian will not likely know. The executor should. (The answer is in Horace’s tax return, Form 8606)
- If Uncle Horace’s total estate (not just this IRA) exceeded $5.43 million, there may have been Federal Estate Tax paid. If this is the case then you, the beneficiary, may be able to take a tax deduction for the Estate Tax paid. This is called the IRD (Income with Respect to a Decedent) deduction. While it is not very common, it can amount to a significant amount of money, and is frequently missed. Many multi-millionaires live very modestly — that’s how they got their millions.
The IRS is not known for much flexibility when it comes to their convoluted rules, a simple mistake in dealing with Uncle Horace’s generous gift can result in unnecessary taxes/penalties. Taking some of your new found money to pay for expert assistance is likely money well spent.
**This article discusses options for non-spouse beneficiaries who inherit a Traditional IRA and are younger than the decedent. The rules are different for spouses, Roth IRAs, and beneficiaries older than the decedent.