It is sad that many federal employees and annuitants are inheriting individual retirement arrangements (IRAs) from nonspousal relatives including parents, siblings, aunts, uncles and other close relatives or acquaintances. It is even sadder that many of these inherited IRA owners are making expensive mistakes with their inherited IRAs that — unlike mistakes made with their own contributory IRAs — cannot be fixed. This column discusses the most common nonspousal inherited IRA beneficiary errors.
No IRA rollovers
A nonspousal beneficiary cannot request a rollover of an inherited IRA. This means no 60 day rollover in which the inherited IRA funds are withdrawn and redeposited into another IRA within 60 days of receipt. An IRA owner can request a rollover of his or her own IRA and a spouse can also request a spousal rollover from a deceased spouse’s IRA. But a nonspousal IRA beneficiary can only do a direct transfer of an inherited IRA to a properly titled inherited IRA. Note that if the nonspousal beneficiary withdraws any amount of the inherited IRA funds, then the withdrawn funds are fully taxable in the year received. This mistake cannot be undone and the IRS has no authority to provide any type of relief. In short, if inherited IRA funds need to be moved, the funds should only be moved as a direct “trustee-to-trustee” transfer to an “inherited” IRA, also called a “death” IRA.
Incorrect account titling
An inherited IRA must be set up and properly titled. In particular, the deceased IRA owner’s name must appear in the account title and the IRA beneficiary must be shown as an inherited beneficiary. For example, the IRA should be titled as “Christopher Jones (Deceased 11/29/2016), IRA FBO of William Jones, beneficiary. Some financial institutions are not using this proper titling. They are instead recording the IRA as an inherited IRA in their internal records. This can result in confusion and worse, may allow the IRA beneficiary to treat the IRA as his or her own IRA which it is not. Incorrect inherited IRA titling will nullify the inherited IRA and once again result in the entire account being distributed and taxable to the extent of pre-taxed funds.
Making disallowed contributions
Beneficiaries are not allowed to contribute to their inherited IRAs. The problem is when beneficiaries are not aware of the fact that they can only contribute to their IRAs – namely their “contributory” IRAs – and not to their inherited IRAs. Upon contributing to an inherited IRA, the entire IRA becomes taxable (such as a traditional IRA) and must be paid out entirely. A lump sum payout also applies to an inherited Roth IRA although in most cases no taxes are due. Once again, this is a disastrous error and cannot be corrected
Delaying required minimum distributions (RMDs)
Under the inherited IRA rules, RMDs generally begin in the year after the IRA owner’s death. A common mistake is for non-spousal beneficiaries to be told that they do not have to start their RMDs until they reach age 70.5. Note that age 70.5 is for owners of traditional IRAs, not to inherited IRA owners. Finally, inherited Roth IRAs are subject to RMDs even though owners of Roth IRAs are not.
Confusion over the “stretch” IRA
Not all nonspousal IRA beneficiaries are permitted to “stretch” their inherited IRAs over their life expectancies. Only beneficiaries who are designated beneficiaries qualify for the “stretch”. A designated beneficiary is a person on the IRA beneficiary form – not in a will – or who inherits through a default provision in the IRA custodial agreement when no beneficiary is named. On the other hand, if beneficiaries inherit through the estate, they are not designated beneficiaries. In that case, the RMDs for the individual(s) inheriting through the estate will depend on when the IRA owner died. If the IRA owner died before his or her required beginning date (April 1 following the year the IRA owner became age 70.5), then the entire inherited IRA would have to be paid out by the end of the fifth year after the year of death. If the IRA owner died after his or her required beginning date, then the beneficiary takes required minimum distributions based on the deceased IRA owner’s single life expectancy had he or she lived.
The Financial Industry National Regulatory Authority or FINRA (formerly called the National Association of Securities Dealers or NASD) issues investor alerts on various types of individual investment accounts including IRAs. FINRA recently issued some guidance on inherited IRAs for nonspousal beneficiaries. Among the important guidance and rules issued by FINRA involving when a nonspouse inherits:
Options for what to do with the inherited IRA
(2) Take a lump sum distribution. Note that the nonspousal beneficiary may incur taxes on the distribution of a traditional IRA. For a Roth IRA, only earnings are taxable if the account is less than five years old at the time of the Roth IRA owner’s death. There is no 10 percent early withdrawal penalty even if the inherited IRA beneficiary is younger than age 59.5; and (3) Decide not to take ownership of all or part of the IRA by “disclaiming” or “renouncing” the inheritance.
If an IRA has multiple beneficiaries, then it is generally suggested that beneficiaries set up separate accounts. If separate accounts are not established, then the amount of the required distributions for all beneficiaries are determined based on the age of the oldest beneficiary. The IRS notes that the designated beneficiary (or beneficiaries) is generally determined on September 30 of the calendar year of the IRA owner’s death. For example, if an IRA owner died sometime in 2016, determination of the account beneficiaries is made on September 30, 2017.
Final tips for nonspousal heirs and beneficiaries
(1) Notify the brokerage firm in a timely manner of an IRA account holder’s death; and
(2) Provide all required documents (for example, a death certificate) in the format and manner stated by the brokerage firm, insurance company, bank or credit union.