A recent column discussed the fact that for individuals age 70 and over during 2018 and who own traditional IRAs, the deadline for taking their 2018 required minimum distributions (RMDs) from their traditional IRAs is Dec. 31, 2018. This is the case even if the individual traditional IRA owner is over age 70, is still working, and therefore has earned income.
There is another RMD deadline for 2018 that affects individuals of all ages who have inherited IRAs from relatives or friends. A non-spousal beneficiary of any age and of any type of IRA – traditional or Roth – and who has elected to directly transfer the inherited IRA assets to what is called a “death” or “inherited” IRA is subject to RMD each year. This column discusses the RMD requirements for “inherited” IRA owners including when they must start, how the RMD is calculated, and the IRS penalty for not taking the RMD in any particular year.
It is important to discuss in more detail how an inherited IRA can be established, as well as some of the pitfalls that potential inherited IRA owners need to be aware of. First, an IRA owner (both a traditional IRA and a Roth IRA owner) needs to name an IRA beneficiary. This beneficiary can be anyone, including a spouse, child, sibling, niece, nephew, distant relative, partner, or a friend. It is also important to name a contingent beneficiary in order to allow more post-death flexibility, or in case the named beneficiary pre-deceases the IRA owner and the beneficiary form was then not updated. Naming an individual on the IRA beneficiary form can allow the beneficiary to receive the inherited IRA proceeds following the death of the IRA owner, and if the inherited IRA beneficiary chooses, over the individual’s lifetime. This is known as the “stretch” IRA and can keep the inherited IRA growing for decades.
It is also important to note that the “stretch” IRA does not protect the IRA from being squandered. The IRS rules state that the inherited IRA is subject to RMD each year, starting the year after the death of the IRA owner. The IRA beneficiary can always withdraw more than the RMD and deplete the IRA whenever he or she wants, similar to receiving a lump sum payment from an inheritance or lottery winnings.
A planning suggestion for IRA owners who have large balances in their IRAs, or if an IRA owner feels that the named beneficiary is not capable of handling a rather large inheritance (whether due to age or a history of financial problems), is to name a trust as beneficiary. A trust can be used to make sure large withdrawals are not made from the inherited IRA. But the trust should also be flexible enough to permit the IRA beneficiary to withdraw a sufficient amount of IRA funds (in addition to the RMD) for items such as health, education and financial emergencies. An attorney would have to draw up the trust and a competent trustee would have to be named to ensure the original IRA owner’s wishes are fulfilled; in particular, that the IRA is protected over the lifetime of the beneficiary. Finally, it should be noted that the US Supreme Court has ruled that inherited IRAs are not creditor-protected in a bankruptcy. This is important for IRA owners to know in case they are thinking about naming IRA beneficiaries who currently have or in the future will have significant debt problems and may be on the verge of filing for bankruptcy.
The following steps and rules must be followed to make sure the inherited IRA will hopefully not be lost immediately after the death of the IRA owner as a result of unintended taxation by the IRS and state revenue tax departments:
- Do not withdraw the inherited IRA. Following the death of the IRA owner, it is crucial that the IRA beneficiary not withdraw any of the inherited IRA assets. It is not uncommon that a non-spousal IRA beneficiary is so anxious to receive some of the inherited IRA assets that he or she withdraws these inherited IRA assets, and in the case of a fully deductible traditional IRA, exposing the entire inheritance to Federal and in some states, state and local income taxes. Beneficiaries should be aware that a withdrawal of any of the inherited IRA assets cannot be undone. Once withdrawn, the IRA inherited assets cannot be transferred to an inherited IRA.
Note that a spousal IRA beneficiary is permitted to directly transfer inherited IRA assets to his or her own IRA with no tax consequences and with no RMD issue until the surviving spouse reaches age 70.5.
- Establish and set up the inherited IRA correctly. Until a properly titled inherited IRA is set up, no funds can be moved from the decedent’s IRA. The inherited IRA should be titled, keeping the name of the deceased IRA owner on the account and adding the beneficiary’s name to the title. An example of a properly titled inherited IRA is: “Barbara Jones IRA, deceased 12-10-18, for benefit of Sandra Jones, beneficiary”. The same correct titling must be done when a trust is the IRA beneficiary. An example of this is: “Peter Smith IRA, deceased 12-14-18, for benefit of Chris Cox, Trustee of the Peter Smith Trust, beneficiary”.
Finally, if there are multiple beneficiaries, then each beneficiary’s share must be set up as a separate inherited IRA. The split must be done as a direct transfer and not a rollover by the end of the year following the death of the IRA owner. This split is done to allow each beneficiary to do a “stretch” IRA based on their own life expectancy.
- No contributions may be made to an “inherited” IRA. An inherited IRA is not the beneficiary’s IRA and therefore the beneficiary cannot contribute to this IRA. If the beneficiary does contribute to his or her inherited IRA, then the beneficiary is deemed to have treated the inherited IRA as his or her own, resulting in the entire account balance becoming subject to Federal and state income taxes in the case of a traditional IRA. An inherited Roth IRA may not be taxable, but if a contribution is made to the inherited Roth IRA account, the inherited Roth IRA is deemed withdrawn and must be withdrawn in its entirety, resulting in the cessation of tax-free growth.
- Inherited IRA assets must be directly transferred. Inherited IRA funds can only be moved as direct transfers (“trustee-to-trustee” transfers) and not as rollovers. If, for example, a beneficiary decides to rollover the inherited assets from one bank or brokerage to another, in which the bank or brokerage pays out the IRA assets to the beneficiary and the beneficiary has 60 days to put the IRA assets in another bank or brokerage, then the inherited IRA assets become subject to taxation and cannot be transferred. This mistake cannot be corrected.
- Make sure the inherited IRA beneficiary takes RMDs each year. Starting the year after the IRA owner dies and every year thereafter, an inherited IRA (non-spousal) beneficiary must take a RMD. RMDs must be taken from inherited traditional and inherited Roth IRAs. There is a 50 percent IRS penalty for not taking a RMD from an inherited IRA. The RMD is calculated by taking the inherited IRA account balance as of December 31st of the year preceding the year in which the RMD must be taken divided by the life expectancy factor of the designated beneficiary. The life expectancy is based on the designated beneficiary’s age and is found in the IRS’ Single Life table, found here on pages 45-46. In addition, if the decedent (the original IRA owner) was over age 70.5 when he or she died and did not take his or her RMD, then the beneficiary must take that RMD. If the RMD is not taken then it is the beneficiary who will be subject to the IRS’ 50 percent penalty. The following example illustrates:
Susan, age 45, was the sole beneficiary of her mother’s traditional IRA. Susan’s mother died on Sept. 20, 2017 before taking her 2017 RMD. Susan made sure that she took her mother’s 2017 RMD. Susan also transferred her mother’s IRA into an inherited IRA in early 2018. Susan must take her first inherited IRA RMD before Dec. 31, 2018. The RMD will be calculated using the inherited IRA’s value as of Dec. 31, 2017, divided by Susan’s life expectancy based on her being age 45 during 2018.
By performing the right steps, an inherited IRA beneficiary can protect his or her inherited IRA funds from excess taxes and unnecessary premature depletion and make the funds last for a lifetime. If any inherited IRA assets are left upon the designated beneficiary’s death, a named contingent beneficiary (named by the original IRA owner) should be able to preserve the inherited IRA assets in the same manner as the designated beneficiary.