Designing and Managing Inherited IRAs

Inherited IRA Fundamentals and Legislative Update 

Certain distributions from IRAs are mandatory every year--they are known as required minimum distributions (RMD)s.  RMDs are taken by the IRA owner during life and designated beneficiaries after the plan owner's death.  The size and timing of RMDs depend on the plan owner's age, and after the plan owner dies, on the status of the subsequent beneficiary.  The RMD rules apply to traditional, Simplified Employee Pension Plan (SEP), Savings Incentive Match Plan for Employees (SIMPLE) Individual Retirement Accounts, 401(k), 403(b) 457(b) profit sharing and other defined contribution plans.  

Rollover Rules and Tactics - the 10 Year Rule 

Rollover is between like plans, in 60 days, from 401(k) to IRAs and to a Roth IRA.  Rollover by a surviving spouse is allowed.  The SECURE Act(s)  (Setting Every Community Up for Retirement Enhancement Act of 2019) SECURE Act 1.0  and SECURE Act 2.0 both impact distribution rules for designated beneficiaries listed on inherited IRAs under Section 401 of the Internal Revenue Code.  Any distributions taken from an IRA almost always are considered income to be taxed to the owner.  When the owner passes away, distributions taken from an IRA are income tax to be reported by the beneficiary.  The withdrawals are taxed in the year they are made.  For IRA owners the Secure Act raised the age for the beginning date of mandatory minimum distributions from age 70 to age 72.  The IRA owner does not take any annual withdrawals prior to the required beginning date.  Also for IRA owners, the Secure Act removed the age cap for making income tax deductible IRA contributions.  

The main change made by the SECURE Act is the 10-year rule.  If the plan participant dies prior to the entire distribution of the plan most designated beneficiaries who are individuals must withdraw the entirety of the plan within ten (10) years with a few exceptions.  These distributions must be completed within 10 years of the death of the owner.  Any amount remaining in the IRA after 10 years is subject to the 50 percent excise tax.  If the IRA owner dies before the required beginning date and the 10-year rule applies no distribution is required for any year before the 10th year (IRS Pub 590-B).  

IRA Required Minimum Distribution Rules 

The RMD rules for designated beneficiaries after the IRA owner's death have now become a bit more complex.  Previously IRAs could be stretched over the life expectancy of eligible designated beneficiaries.  This stretch out provision also had applied to trusts provided that the trust was a see through trust and had the correct eligible designated beneficiaries.  To be a see through trust the trust must be valid under state law, must have been irrevocable during the owner's life or become irrevocable on the owner's death, the beneficiaries must be identified from the trust instrument itself and the trustee must provide required documentation to the IRA plan custodian by October 31 of the year following the IRA owner's death.  The trust itself is not a designated beneficiary but its beneficiaries are treated as designated beneficiaries.  

The identity of the designated beneficiary must be finalized by September 30 in the calendar year after the year in which the IRA owner passed away.  For an individual to be counted as a designated beneficiary, he or she must have been listed on the beneficiary designation form on the date that the plan participant passed away.  Some beneficiaries, such as a spouse, may automatically be listed as beneficiaries under the terms of the retirement plan.  It is possible for the beneficiary's interest to cease between the date of death and September 30 of the following year if they disclaimed or settled their interest.  

The Five Year Rule 

The SECURE Act did not change the provisions of the five (5) year rule.  Under the 5-year rule, a beneficiary that is not a designated beneficiary must withdraw the entirety of the plan within 5 years if the owner died prior to the required beginning date.  A non individual beneficiary such as the Decedent's estate or certain trusts still is subject to the 5 year rule.  Similar to the 10 year rule the time period to withdraw the entirety of the IRA proceeds falls on December 31 of the fifth year of the IRA owner's death.  Any funds that remain after five years are subject to the 50 percent excise tax.   Some trusts are subject to the five year rule--although see through trusts under the SECURE Act are subject to the 10 year rule.   Beneficiary designation forms allow the proceeds from an inherited IRA to be distributed directly to the intended recipient with the greatest possible tax advantages and creditor protection.  

A new category of beneficiaries was created by the SECURE Act known as "eligible designated beneficiaries".  Eligible designated beneficiaries are generally able to stretch out minimum distributions over their lifetime.  Such beneficiaries are surviving spouses, chronically ill beneficiaries and disabled beneficiaries, beneficiaries who are less than 10 years younger than the plan participant and minor children.  These categories all have their own specific rules as well.  

What Surviving Spouses Need to Know and Do or Avoid 

Surviving spouses of a deceased plan participant generally receive the most favorable treatment of any "eligible designated beneficiary" when it comes to the the rules for required minimum distributions.  IRC 409(a0(9)(E)(ii)(l). 

One of the reasons surviving spouses receive favorable tax treatment is that they have several options when receiving an IRA as a beneficiary: 

  • When retitling the ownership of the IRA a sole beneficiary surviving spouse may elect to become the new owner of the IRA instead of an inherited beneficiary; 
  • if they choose to do so, surviving spouses could also remain as an inherited beneficiary;
  • the surviving spouse may roll the deceased spouse's IRA into an existing IRA belonging to the surviving spouse; 
  • perhaps the biggest benefit to a surviving spouse is that the spouse may avoid the 10-year rule
  • if the spouse becomes the owner of the IRA, RMDs are then calculated as if the surviving spouse is the new owner and is stretched out over his or her remaining life expectancy.  

Multiple Beneficiaries:  Problems and Solutions 

One of the main issues that can arise with multiple beneficiaries is when IRAs pay to a trust and not all of the beneficiaries are subject to the 10-year rule.  Designated beneficiaries who are exempt from the 10 year rule are known as "eligible designated beneficiaries".  For these beneficiaries they can use their life expectancy to determined the yearly RMD.  Whether a beneficiary qualifies as an "eligible designated beneficiary" is determined on the date of death of the plan participant.  

A charity would not qualify as a designated beneficiary and could subject the entire trust to the 5 year rule.  

Changing Custodians 

An IRA custodian is a financial institution that holds the investment in the IRA and monitors the account to make sure IRA rules are followed.  If the IRA contains investments other than stocks or mutual funds such as real estate or private notes a self-directed custodian may be necessary.  Changing IRA custodians involves moving IRA funds from one investment company to another.  This transfer can be accomplished either by a direct rollover, a trustee to trustee transfer, or by withdrawing the funds and then depositing them into a new IRA account within 60 days.  If the rules are followed for any of these transfers no income tax is due when they occur.   Please consult your CPA and investment advisor regarding updated rules 

If you wish to discuss how your estate planning and IRA distributions are best optimized for your beneficiaries.  Please call me at 307.200.1914.