Inheriting an Individual Retirement Account

Inheriting_IRAMany decisions need to be made when inheriting an Individual Retirement Account (IRA), including the time frames for making these decisions and the related income tax issues.  The following is a list of the key issues:

First, it is important to obtain a copy of the beneficiary designation on file with the financial institution where the IRA account is held.  An IRA account holder can change their beneficiary designation as often as they like while they are alive.  But once the account holder dies, the last submitted designation will govern what happens with the account.

Second, depending on the financial circumstances of the designated beneficiary, it might make for the primary beneficiary to “disclaim” the account, thereby letting the account pass to one of the secondary beneficiaries.  That is done via a formal legal document called a “disclaimer.”  In a disclaimer you are simply requesting that the financial institution treat the signing beneficiary as if they too are deceased, thereby permitting the account to pass to the next successive beneficiary.

Third, if an IRA account holder has a surviving spouse, the spouse gets to elect one of two different ways in which the account will pass to that spouse.  You can elect for the account to be treated as an “inherited” IRA, which essentially means that they will continue to take annual Required Minimum Distributions (RMDs) based on the surviving spouse’s life expectancy starting the year of death.  In contrast, the spouse could instead elect to “roll over” the IRA.  When that is done, the tax rules essentially treat the account as if it was the surviving spouse’s from the beginning.

In order to avoid taxes when rolling over an IRA into your own, the amount withdrawn from the initial account must be deposited into the surviving spouse’s own account within sixty (60) days of the withdrawal.  To avoid the possibility of immediate taxation tax professionals generally recommend an IRA to IRA transfer.

Fourth, the ability to “stretch out” IRA distributions over a longer period of time is frequently advocated by tax planners, especially in scenarios when the surviving spouse and/or other heirs have sufficient assets outside the IRA.  However, whether or not IRA distributions can be stretched out over a long period of time will depend in part whether the account has a “Designated Beneficiary.”  Certain complicated legal requirements must be satisfied to determine whether a “trust” will qualify as a “Designated Beneficiary”.

If there is a problem with the language of the trust document it is possible that the trust will not qualify as a Designated Beneficiary.  This means that the entire account must be withdrawn within five (5) years of the date of death of the original account holder.  The 5 year rule will likely result in an increased income tax liability on the withdrawals.  It is important to note that problems with “Designated Beneficiaries” can be corrected or, in some cases, removed by September 30 following the year of death, to avoid the 5 year rule. 

When the IRA beneficiary is to be a trust, much care and attention must be paid to drafting and administering the trust and the IRA.  If done properly, a trust as an IRA beneficiary may be split into separate trust shares for individual beneficiaries, in a manner where each respective individual trust beneficiary’s life expectancy will apply to RMDs.  If that is the case, separate IRA accounts for each respective trust beneficiary must be established by December 31 of the year following the year of death.

In summary, consult your estate planning attorney and your financial advisor when an IRA or other qualified retirement benefit is an important part of your assets.

Author: John S. Polgrean, Esq.