The inherited IRA, when implemented properly, can be a great vehicle for transferring wealth to your heirs, maintaining the tax-deferred status until much later. The problem is, there are some very specific terms which must be met in order to achieve the stretch – and if you screw it up, there’s definitely not a do over in most of these cases.
First, let’s review the specifics for an inherited IRA. When an IRA account owner dies, the beneficiary is eligible to re-title the account as an inherited IRA in the name of the deceased owner, and then must take distribution of the entire account over the coming 10 years. This is the default rule, but as covered earlier there are longer payout periods for certain eligible designated beneficiaries.
Keep in mind, these inherited IRA rules apply to both Traditional and Roth IRAs – even though the Roth IRA’s original owner is not subject to RMD, their beneficiaries are.
7 Mistakes With Inherited IRAs
Here are some of the common mistakes that can be made when attempting to stretch an IRA:
- Not properly titling the account – if the account is set up in the name of the non-spouse beneficiary with no reference to the fact that it’s inherited, the funds would be immediately taxable and the IRA would be considered distributed. There’s no remedy to this one, the account has to be titled as “John Doe IRA (Deceased January 1, 2009) FBO Janie Brown” or something very similar, making it very clear that the account is inherited. If the account is set up in the name of a non-spouse beneficiary (and not referencing that it is inherited), the funds would be immediately taxable and the IRA would be distributed – all tax deferral is lost.
- Doing a “rollover” – While it may seem like a simple question of semantics, there is a technical difference between a direct trustee-to-trustee transfer and a rollover. The trustee-to-trustee transfer is, as the name implies, a transfer directly between one trustee and another – the account owner never has possession of the funds. On the other hand, a rollover is when the beneficiary receives a payment made out in his own name, which he then deposits into an IRA. A rollover is disallowed in attempting to set up an inherited IRA – you must always do a direct trustee-to-trustee transfer.
- Neglecting timely transfer – sometimes estates can be tied up for years getting every-thing sorted out. IRAs and 401(k) plans should not have this problem, as generally there is a specific beneficiary or beneficiaries designated on the account documentation. It is critical to transfer the funds into a properly titled account before the end of the year following the year of the deceased owner’s death – otherwise any stretch IRA option is lost (for those eligible designated beneficiaries), and the funds will have to be paid out via the factor which applies to the oldest primary beneficiary of the account (if there is more than one beneficiary).
- Failing to take RMD for year of death – if the IRA owner dies after his Required Beginning Date, or RBD, a Required Minimum Distribution must be taken for the year of his death, and cannot be included in a transfer to an inherited IRA. This one can cause some hiccups, but in general can be resolved if caught in a timely fashion by taking the distribution in the name of the decedent and paying the applicable penalties for excess accumulation. If the amount including the RMD is transferred to an inherited IRA and isn’t caught quickly, it could negate the stretch altogether, causing big headaches.
- Missing or neglecting RMD payments – if the eligible designated beneficiary (EDB) forgets to take the Required Minimum Distribution payments in a timely fashion, technically the five-year rule could kick in, requiring the entire balance to be paid out within five years, rather than the beneficiary’s lifetime. However, it is possible to recover from this mistake, according to the outcome of an IRS Private Letter Ruling (PLR 200811028, 3/14/2008). What happened in this case was the beneficiary neglected to take two years’ worth of RMD, and then corrected her mistake in the third year, taking all three years’ worth of RMD, followed by paying the penalty (50%) on the missed two years. The IRS ruled the failure to make these distributions in a timely fashion does not make the five-year rule apply. Since she maintained the appropriate distributions, caught up on the “misses” and paid the penalties, she is allowed to continue stretching the IRA over her lifetime.
If the beneficiary is a regular designated beneficiary (not an EDB), subject to the 10-year rule, neglects to take distribution by the end of the 10th year following the original owner’s death, the “excess accumulations” excise tax will be applied – 50%. That’s right, 50% of the amount that should have been distributed will be assessed as tax on this account if the distribution isn’t done in a timely fashion.
- Not properly designating the beneficiary(s) on the account – IRS regulations state that the beneficiary must be identifiable in order to be eligible for the stretch IRA provision. This means naming an individual or individuals as specific beneficiaries on the account forms, or designating a proper see through trust (with specific beneficiaries named) as the beneficiary. The account form cannot have something ambiguous like “as stated in will” – since this does not name an identifiable beneficiary. In addition, if the original IRA beneficiary is a trust and any beneficiary of the trust is not a person, then the stretch IRA provision is lost for all beneficiaries.
- Transferring the balance to a trust – if a qualified see-through trust is the beneficiary of the IRA, the balance of the funds in the IRA are NOT transferred to the trust. Rather, the IRA is transferred directly to a properly-titled inherited IRA, and then RMDs are taken from the inherited IRA and paid to the trust. According to the trust’s provisions, the payments are then made to the trust beneficiary(s). If the payments are simply passed through the trust to the trust beneficiary(s), then each beneficiary will be responsible for any tax on the distribution. If the funds are accumulated in the trust, they are taxable to the trust as ordinary income.
Obviously this isn’t an exhaustive list, but a sampling of the more common errors that folks make when attempting to set up an inherited IRA. Done properly, this arrangement can turn an IRA of a sizable amount in your lifetime into a significant legacy to your heirs. Proper setup is very important – get a professional to help you with it if you are confused by how this works!
Originally posted at https://financialducksinarow.com/858/7-mistakes-with-inherited-iras/