With Rachel Sheedy, Contributor to the Kiplinger Retirement Report
Your spouse or your rich uncle bequeaths you the money in their IRA. Besides being grateful, what do you do? How do you handle such a windfall? Decisions must be made quickly and it even becomes more complicated if you’re part of a shared inheritance.
Rachel Sheedy takes us through the four steps to take if you find yourself in this position as written for Kiplinger’s Retirement Report below:
- Retitle the account. Because you can’t roll the money into your own IRA, you must create a properly titled inherited IRA. “It must include the name of the decedent and the beneficiary, clearly identifying who is who,” says Denise Appleby, chief executive officer of Appleby Retirement Consulting, in Grayson, Ga. For example, the account could be retitled to “Mary Smith (deceased August 8, 2016) IRA for the benefit of Joe Smith.” You should also name successor beneficiaries.
If you want to “stretch” the benefits of the tax shelter over your lifetime, you must take annual withdrawals based on your life expectancy, beginning no later than the end of the year after the year the original owner died. Those distributions are taxable from an inherited traditional IRA, but tax-free from an inherited Roth IRA. Otherwise, you must clean out the account within five years of the owner’s death if he died before age 70 or, if he died past that age, you must use the deceased owner’s life expectancy to take distributions.
- Split an IRA. While an owner can name multiple IRA beneficiaries, it can pay off for those heirs to divide the IRA after the owner’s death. If they remain together on the inherited IRA, the life expectancy of the oldest beneficiary must be used to calculate RMDs.
Instead, each beneficiary should set up an inherited IRA so that his or her own life expectancy comes into play. This is particularly important if there is a large age difference between heirs. If a 60-year-old son and a 22-year-old granddaughter are named heirs to a traditional IRA, for instance, separating the accounts would set the 22-year-old’s first RMD at 1.6% of the account balance, compared with a 4% withdrawal required by the 60-year-old. That means more of her money can stay in the account to grow tax-deferred. (You can always take more than the minimum if you need to.)
The IRA must be split by December 31 of the year after the year the owner died. Each heir can then devise a personal investment strategy and, notes Jeffrey Levine, chief retirement strategist for IRA advice firm Ed Slott and Co., name his or her own beneficiaries.
- Pay out a nonperson’s share. If you are named an heir along with a charity or other nonperson entity, you’ll want to pay off that share no later than September 30 of the year following the owner’s death. Otherwise, you’ll lose the chance to stretch the IRA over your own lifetime because all assets must be disbursed within five years of the owner’s death if the owner died before age 70. If the owner died after that age, you’d have to take annual withdrawals based on the deceased’s remaining life expectancy, as set out in IRS tables.
- Turn it down. What if you think the IRA could be better maximized by the next beneficiary in line? “If the heir does not desire the income or the additional asset, he can disinherit his interest in the IRA,” says Joe Heider, president of Cirrus Wealth Management, in Cleveland.
For example, a daughter may be the primary beneficiary but decides she wants her children, who were named as contingent beneficiaries, to inherit the IRA. They could stretch distributions out longer and perhaps pay tax on the money in a lower bracket. The daughter can “disclaim” the IRA and it will pass to the contingent beneficiaries. The heir disclaiming must typically do so within nine months of the original owner’s death, and the heir cannot have taken control of the assets before deciding to disclaim the inheritance.
If you decide you don’t want the IRA, you can’t simply pick someone to take your inheritance. Instead, follow the path on the beneficiary form to see where the money will go before making the irrevocable decision to disclaim the money.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: You think you’re in line to get an inherited IRA? Has someone got you named as a beneficiary? Well, it’s important to know what happens if, in fact, you are lucky enough to inherit some money in an IRA, so to that point, I’ve asked Rachel Sheedy, she’s from Kiplinger’s retirement report, and she is here with us to discuss just that: how to make the most out of an inherited IRA. Rachel, welcome to the show.
Rachel Sheedy: Thanks for having me.
Steve Pomeranz: An inherited IRA, unfortunately, comes at one of the most tumultuous times in life. You’re dealing with the death of a loved one, but you’ve got to make some important decisions about how to handle this account that has been plopped into your lap. Take us through the initial stages and let’s talk about some of the strategies.
Rachel Sheedy: Sure, yeah, one the worst things that can happen, losing a loved one. If you happened to be named as a beneficiary of an IRA, you do have some opportunities to make the most of that account, but there are some time limits that you need to be aware of. You don’t have to necessarily make them immediately in the first month, but there are lots of little rules you need to know about. One of the key things though is the kind of beneficiary you are, so spouse beneficiaries … Say it’s a husband that has died and it’s a wife who is inheriting the account, she’s got a lot more flexibility than if it’s an adult child or some other non-spouse beneficiary who’s inheriting the account. It’s that —
Steve Pomeranz: What kind of flexibility?
Rachel Sheedy: Well, a spouse beneficiary can take the account as her own. She can wait to make that decision. If she’s a young spouse, if she’s under 59 and a half, she might want to keep the inherited IRA, because beneficiaries don’t pay an early withdrawal penalty when they withdraw money, but if she takes it as her own, and she’s younger than 59 and a half, and she needs to tap the account, she would get hit with an early withdrawal penalty, so —
Steve Pomeranz: So, you’re talking about the difference between leaving it in a beneficiary IRA. Now, let’s discuss that for a second because I think a lot of people don’t understand that when you do inherit an IRA, the money has to go somewhere and it doesn’t necessarily get rolled into your IRA account. A separate account is set up, so tell us about a beneficiary IRA account.
Rachel Sheedy: Right, so this particularly applies to non-spouse beneficiaries, an adult child, a friend, niece, whoever might be inheriting it who’s a non-spouse. They need to re-title the account. They can’t just put the money in their own account. It could be an accidental taxable event if they do that, and they can’t just keep it in the deceased person’s name. They need to re-title it as an inherited IRA, and it needs to clearly state the name of the person who died, and the name of the beneficiary. It could say something like “Mary Smith, deceased August 8th, 2016. IRA for the benefit of Joe Smith”.
Steve Pomeranz: Okay, very important, and also, really any decent financial institution, bank, brokerage, firm or other, will know this, and will guide you in that way.
Rachel Sheedy: They should be able to, but it is important to be up to speed on the rules, just to make sure that you meet the deadlines and do this properly so you don’t accidentally get hit with penalties or lose out on a chance to stretch the IRA for decades.
Steve Pomeranz: Yeah, I want to talk about stretching it in a second, but getting back to the spouse, so spouse has a choice to keep this beneficiary IRA, or roll that money into his or her own IRA, is that right?
Rachel Sheedy: Exactly, yes, and that is something that only a spouse can do, so they’ve got some different decisions to make. In most cases, it is beneficial for the spouse to take the account as their own, but there are a few instances where … It’s like the younger spouse [crosstalk 00:04:10].
Steve Pomeranz: Yeah, exactly, you said that if a spouse is below 59 and a half, and wants to access some of the money. If they had rolled it into their own IRA, they’d have to pay a ten percent penalty, but in a beneficiary IRA, they would not.
Rachel Sheedy: Exactly, and then so they could leave it in the beneficiary IRA until 59 and a half, and then they could later take it as their own, so they just have a lot more flexibility than non-spouse. I’m sure —
Steve Pomeranz: So, let’s talk about this idea about stretching the benefits of that tax shelter over a lifetime. How does that work?
Rachel Sheedy: Basically, if you inherit an IRA and you re-title the accounts in the inherited IRA, and particularly for the sole beneficiary on the account. You can choose to use your own life expectancy to take out required minimum distribution, all beneficiaries, non-spouse beneficiaries have to take RMDs, even if they’re inheriting a Roth IRA, and so Roth IRA or traditional IRA, they’re going to have to take RMDs and the longer the life expectancy, the less money you have to take out every year, and so the more money can stay in the account and can grow, and if it’s a young person, say it’s a 22-year-old grandchild who’s inheriting the IRA, that money could grow for decades and they’d have to take out a very minimal amount. They could always take out more if they wanted to, but the minimum amount that they would have to take out would be significantly less by using their —
Steve Pomeranz: So, you mentioned the RMD well required minimum distribution, so there is a minimum distribution and in some cases, it is required so that’s where the term RMD comes from. Here’s the clue, guys, the government’s going to get the taxes on that money. That’s the contract between the IRA holder and the government is that eventually you’re going to be forced to take this money out of the account, and the government is going to get its due, so the government is your partner when it comes to owning an IRA. Don’t ever forget that, because that means that the government may own 15% or 20% or 25% of that IRA down the road. You want to put that in your calculations. Getting back to the point here. If you’re a beneficiary quite young, the amount of time left based on typical life expectancies is much longer so you’re taking out smaller and smaller amounts the younger you get, so you can really stretch this thing over many, many years and really enable it to grow tax-deferred, right?
Rachel Sheedy: Exactly, exactly and the key thing too is that if you inherit a Roth IRA, you do have to take required distributions, which regular owners don’t have to do, but that money’s qualified. It will come out tax-free, so —
Steve Pomeranz: So, remember Roths are always tax-free, but most of the time Roths are tax-free, so even though you’re required to take money out, you won’t be taxed on it. Now, —
Rachel Sheedy: Right, and the less you can take out, the longer that can grow tax-free tooif you’re inheriting a Roth IRA.
Steve Pomeranz: And tax-free is always better than tax-deferred, always, always, always, always, so the government is not your partner when the earnings are growing tax-free, so you get to keep pretty much all of the future growth and benefit. Well, what happens if the owner has named multiple IRA beneficiaries? How does that work? How should the beneficiaries treat that?
Rachel Sheedy: If you’ve got multiple named beneficiaries to an account, the best idea is generally to split the account, so that each heir can use their own life expectancy. If they don’t split the account, then the life expectancy of the oldest beneficiary would have to be used for required minimum distribution, so if there’s a significant age difference between beneficiaries, that could really be a disadvantage to the younger ones. Say it’s a 55-year-old and a 30-year-old and they don’t split the account. They’re going to have to use the 55-year-old’s life expectancy, but if they split it, the 30-year-old can use her own life expectancy and she can take out smaller minimum distributions and let that money grow for a longer period.
Steve Pomeranz: So, that’s pretty smart. If you’ve got 10 or 15 years between … An age differential between your sibling, and you kept the IRAs together, then the distribution would be based on the life expectancy of the older sibling, which would not really be as advantageous to the younger sibling, so make sure that you consider splitting the IRA. Now, what happens if one of the beneficiaries is not a person. Let’s say it’s a charity. How does that work?
Rachel Sheedy: Yeah, so if there is a charity that’s named as a beneficiary, some other non-person entity, usually it’s a good idea to pay off that share. You’ve got to do that by September 30th of the year following the original owner’s death, and you need to do that before you can split the account. You want to take care of that, and then you can split it by December 31st of the year following the original owner’s death, if you’ve got multiple beneficiaries, other ones on the account, so —
Steve Pomeranz: Yeah, so it kind of makes sense. It’s pretty logical, so if a charity is named, make sure you distribute that money to the charity before the date that Rachel just mentioned, and then you won’t get into any problems or trouble doing —
Rachel Sheedy: The reason to do that is so that you might have to disperse the money faster if you leave the charity, leave a non-person entity as a beneficiary, and if you pay out that share, then you don’t have to worry about that problem and you can use your own life expectancy, and that’s where the key point takeaway in all of this is that you want to try to be able to use your own life expectancy. You split the account, you can also name your own successor beneficiaries. You can do your own investing strategy without having to coordinate with —
Steve Pomeranz: It’s all about control. You get to keep control, and that’s a good thing. My guest is Rachel Sheedy from Kiplinger’s Retirement Report. Rachel, what if I don’t want the IRA, do I have to accept it as a beneficiary?
Rachel Sheedy: No, you don’t have to. If for some reason you decide you don’t need the money or there are contingent beneficiaries named after you and you think it’d be more advantageous for them to get it. Say that they’re younger than you are, maybe have a lower tax rate. You can disclaim your interest in the IRA, and basically when you disclaim, you’re saying, “I don’t want this. Take me out of line for it.” And it will go to the next person. A key thing to pay attention to if you happen to do this, you don’t get to pick who the money goes to when you pass it, so if you’re concerned about that, where the money’s going to end up, you need to follow the path of where the money will end up if you decide to turn your portion down.
Steve Pomeranz: Well, let’s say you’re older. You really don’t need the money and plus maybe you’re in a higher tax bracket. Your kids need the money. They’re named as contingent beneficiaries. You disclaim it as the primary beneficiary. It goes to the kids. They’re in a lower tax bracket and they get to stretch out those distributions over many more years because they’re so much younger.
Rachel Sheedy: Yes, yeah, so it definitely could be advantageous and it’s a move perhaps to consider if you feel like you don’t need the money.
Steve Pomeranz: All right, my guest, Rachel Sheedy from Kiplinger’s Retirement report. Four ways to make the most of an inherited IRA. Thanks, Rachel.
Rachel Sheedy: Thank you.