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Inherited IRA

 

Inherited IRA’s can be tricky.  There are a lot of rules surrounding;

 

  • Establishment and required minimum distribution (“RMD”) deadlines
  • Options available to spouse and non-spouse beneficiaries
  • Strategies for deferring required minimum distributions
  • Special 60 day rollover rules for inherited IRA’s

 

Establishment Deadline

 

If you or your client is a beneficiary of an IRA or an employer sponsored retirement plan, they have the option of setting up an Inherited IRA to avoid immediate taxation and penalties on the distribution.  The deadline to establish the inherited IRA is December 31st of the year following the decedent’s date of the death.   If the beneficiary misses that deadline, they will be force to withdraw the full balance of the retirement account within a 5-year period.

 

RMD Deadline

 

If you successfully establish an inherited IRA by the December 31st deadline, if you are non-spouse beneficiary, you will be required to start taking a “required minimum distribution” based on your own life expectancy in the calendar year following the decedent’s date of death.

 

Here is the most common RMD mistake that is made.  The beneficiary forgets to take an RMD from the IRA in the year that the decedent passes away.  If someone passes away toward the beginning of the year, there is a high likelihood that they did not take the RMD out of their IRA for that year. They are required to do so and the RMD amount is based on what the decedent was required to take for that calendar year, not based on the life expectancy of the beneficiary.  A lot of investment providers miss this and a lot of beneficiaries don’t know to ask this question.  The penalty?  A lovely 50% excise tax by the IRS on the amount that should have been taken.

 

Distribution Options Available To A Spouse

 

If you are the spouse of the decedent you have three distribution options available to you:

 

  • Take a cash distribution
  • Rollover the balance to your own IRA
  • Rollover the balance to an Inherited IRA

 

Cash distributions are treated the same whether you are a spouse or non-spouse beneficiary. You incur income tax on the amounts distributed but you do not incur the 10% early withdrawal penalty regardless of age because it’s considered a “death distribution”.  For example, if the beneficiary is 50, normally if distributions are taken from a retirement account, they get hit with a 10% early withdrawal penalty for not being over the age of 59½.  For death distributions to beneficiaries, that 10% penalty is waived.

 

#1 Mistake Made By Spouse Beneficiaries

 

This exemption of the 10% early withdrawal penalty leads me to the number one mistake that we see spouses make when choosing from the three distribution options listed above.   The spouse has a distribution option that is not available to non-spouse beneficiaries which is the ability to rollover the balance to their own IRA.  While this is typically viewed as the easiest option, in many cases, it is not the most ideal option.  If the spouse is under 59½, they rollover the balance to their own IRA, if for whatever reason they need to access the funds in that IRA, they will get hit with income taxes AND the 10% early withdrawal penalty because it’s now considered an “early distribution” from their own IRA.

 

Myth: Spouse Beneficiaries Have To Take RMD’s From Inherited IRA’s

 

Most spouse beneficiaries make the mistake of thinking that by rolling over the balance to their own IRA instead of an Inherited IRA they can avoid the annual RMD requirement.  However, unlike non-spouse beneficiaries which are required to take taxable distributions each year, if you are the spouse of the decedent you do not have to take RMD’s from the inherited IRA unless your spouse would have been age 70 ½ if they were still alive.  Wait…..what?

 

Let me explain.  Let’s say there is a husband age 50 and a wife age 45. The husband passes away and the wife is the sole beneficiary of his retirement accounts.  If the wife rolls over the balance to an Inherited IRA, she will avoid taxes and penalties on the distribution, and she will not be required to take RMD’s from the inherited IRA for 20 years, which is the year that their deceased spouse would have turned age 70 ½.   This gives the wife access to the IRA if needed prior to age 59 ½ without incurring the 10% penalty.

 

Wait, It Gets Better……

 

But wait, since the wife was 5 years young than the husband, wouldn’t she have to start taking RMD’s 5 years sooner than if she just rolled over the balance to her own IRA?  If she keeps the balance in the Inherited IRA the answer is “Yes” but here is an IRA secret. At any time, a spouse beneficiary is allowed to rollover the balance in their inherited IRA to their own IRA.   So in the example above, the wife in year 19 could rollover the balance in the inherited IRA to her own IRA and avoid having to take RMD’s until she reaches age 70½.  The best of both worlds.

 

Spouse Beneficiary Over Age 59½

 

If the spouse beneficiary is over the age of 59½ or you know with 100% certainty that the spouse will not need to access the IRA assets prior to age 59 ½ then you can simplify this process and just have them rollover the balance to their own IRA.  The 10% early withdrawal penalty will never be an issue.

 

Non-Spouse Beneficiary Options

 

There are only two non-spouse beneficiary options:

 

  • Cash Distribution
  • Rollover to an Inherited IRA

 

Non-spouse beneficiaries do not have the option of rolling over the balance to their own IRA and RMD’s need to start the calendar year after the decedent’s date of death.

 

Advanced Tax Strategy for Non-Spouse Beneficiaries

 

It’s frequently the case that non-spouse beneficiaries, which in many cases are the children of the decedent, do not need the income from distributions that are required to be taken each year from the inherited IRA.  There is a tax strategy to avoid this tax hit.  If the beneficiary is covered by an employer sponsored retirement plan or can contribute to a pre-tax IRA, we will often advise them to increase their pre-tax contributions to the retirement plan by the amount of the annual RMD.

 

For example, parent passes away and the child inherits their 401(K) account. They rollover the balance to an Inherited IRA and the following year they are required to start taking their required distribution of $6,000.  In 2019, the employee deferral limit to a 401(k), 403(b), or a 457(b) plan is $19,000 for employees under the age of 50 and $25,000 for employees age 50 and older.  If the child is only currently contributing $10,000 to their 401(k) plan, we will advise them to take the RMD from the inherited IRA in January, increase their contributions to the 401(k) plan by $6,000 for the year, and use the money they received from the IRA to supplement the money that they are losing in their paycheck from the increased contributions to their retirement account.

 

The $6,000 distribution from the inherited IRA represents taxable income but then they are lowering their W2 taxable income by $6,000 via the increased pre-tax contributions to the 401(k) plan.  It’s a back door way to nullify the tax hit on those RMD’s from the inherited IRA.

 

60 Day Rollover Mistake

 

There is a 60 day rollover rule that allows the owner of an IRA to take a distribution from an IRA and if the money is deposited back into the IRA within 60 days, it’s like the distribution never happened. Each taxpayer is allowed one 60 day rollover in a 12 month period.  Think of it as a 60 day interest free loan to yourself.

 

Inherited IRA’s are not eligible for 60 day rollovers.  If money is distributed from the Inherited IRA, the rollover back into the IRA will be disallowed, and the individual will have to pay taxes on the amount distributed.

 

Michael Ruger

About Michael………

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

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Investment advisory services offered through Greenbush Financial Group, LLC. Greenbush Financial Group, LLC is a Registered Investment Advisor. Securities offered through American Portfolio Financial Services, Inc (APFS). Member FINRA/SIPC. Greenbush Financial Group, LLC is not affiliated with APFS. APFS is not affiliated with any other named business entity. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.