By Gary Brooks, CFP
We are in the middle of a huge transfer of wealth. People who prospered in the decades after World War II are passing on in large numbers. Also, now that 401k plans and Individual Retirement Accounts (IRAs) have existed for a generation, assets in these types of accounts are increasingly being transferred.
It used to be that pension payments, bank savings, real estate and life insurance proceeds were the primary elements of wealth transfer. Inheriting those assets is relatively simple compared to the transfer and distribution rules tied to IRAs. The tax code and its treatment of inherited IRA assets is complex. Traditional IRAs and Roth IRAs have different rules. And options for spouses differ from other beneficiaries.
Lack of clarity and planning often eliminates the opportunity to stretch the benefits of the IRA for decades more.
Current IRA owners and beneficiaries would be wise to address the following common mistakes and misunderstandings of inherited IRAs.
The beneficiary designation
IRA assets do not transfer at the direction of a will. The beneficiary is designated on the account and the asset transfers outside of probate. If you do not name a beneficiary, the assets defer to your estate and are liquidated, losing the tax-deferred character of the IRA. The whole point of the IRA is to benefit from tax-deferral. It can make a difference of thousands of dollars to extend that benefit as long as possible. To do so, make sure that the custodian of your account has the correct beneficiaries on file.
In some cases, it may be wise to name a beneficiary other than your spouse. If your spouse will have enough retirement income from other sources, consider a younger beneficiary who can benefit from a longer holding period.
Rolling over to your own IRA
If you are a non-spouse beneficiary of an inherited IRA, do not roll over the IRA or transfer it into your existing IRA. This can make the entire distribution taxable. You can move an IRA to the same firm or advisor that you currently use but the titling of the account must still include the name of the original owner. The IRA should be re-titled to “Joe Smith, IRA, deceased, FBO (for the benefit of) Jane Smith.” If there are multiple beneficiaries of a single IRA, it can be broken up into individual accounts still following the appropriate titling.
Not revising the investment holdings to fit your needs and goals
Often, beneficiaries are grateful to have inherited the money and there are emotional considerations that cause them to leave the account as is. Particularly if the money is being passed from one generation to the next, it is likely that the investments in the account should be revised to map to the goals and investment strategy of the beneficiary. Inheriting an IRA full of income-producing conservative investments may not be suitable for someone 30 years younger than the original owner of the account. Plus, as with any investments, markets zig and zag over time making it prudent to monitor the account and rebalance as necessary.
A common misperception is that the IRA must be liquidated within five years. This is not always true. People also often fail to make annual required minimum distributions from the account. If you miss the required minimum distribution, the IRS will charge a penalty equal to 50 percent of the amount you were supposed to withdraw.
Paying more tax than you have to
If the original owner of a Traditional IRA made non-deductible contributions over the years, you don’t have to pay tax on that amount. IRS Form 8606 from the original owner’s tax return will indicate if the owner had non-taxable basis in the IRA.
Another way to pay double the necessary taxes is by failing to account for estate taxes paid as a result of the IRA balance in the original owner’s estate. This only applies to people who had enough assets to trigger the estate tax. But the tax deduction for income in respect of the decedent is sometimes overlooked.
Giving IRA assets to heirs who will spend it right away
If you have the luxury of being able to gift different types of assets, don’t give an IRA to someone who is likely to liquidate it and spend it quickly. Instead, give the tax-deferred asset to someone who can get the most out of it. Or consider giving it to a charitable organization.
With a little planning, the value of IRAs can be extended significantly for beneficiaries. Make sure you understand your options or see a professional for help.