Inherited retirement accounts

The October edition of AARP Bulletin contained an article by Jane Bryant Quinn that dealt with the issue of inherited qualified retirement funds.

“One wrong move,” states Ms Quinn, “and the entire account could be taxed rather than tax deferred.”

The biggest gift of a qualified retirement fund, whether an IRA, 401k, 403b, or 457, is the tax shelter it provides. Therefore, it is imperative to preserve that benefit as much as possible. The same rules apply for each type. For simplicity, this article will refer to IRAs throughout.

Generally, any funds withdrawn from a traditional IRA are taxed as ordinary income. An heir should determine whether the account contains any non-qualified contributions. The owner has already paid the taxes on these funds and they are generally not taxed upon withdrawal. If the inherited fund is a Roth IRA, these are generally tax free.

Often heirs make costly mistakes in handling inherited retirement accounts. The beneficiary’s choices as to how much and when to take money out depend upon whether the person inheriting is the spouse or non-spouse of the deceased and age of the owner of the IRA at death and age of the beneficiary at the time of inheriting. Here are some strategies for maximizing the tax deferral benefit of an inherited retirement account.

Spouse inherits from spouse

Taxation rules require that minimal distributions (RMDs) be made when the owner turns 70 ½. These RMDs are taxed at the ordinary income rate of the owner at the time of withdrawal.

Mickey Midas died at age 71 and left his IRA to his wife. Mary Midas was four years younger than Mickey. Mary understood she could have taken the IRA in a lump sum. She sensibly chose not to because that would have required her to pay taxes immediately on the full amount. Mary wisely re-titled the IRA in her own name. This allowed her to leave the money in the account tax free until she is 70 ½. Had she left the IRA in Mickey’s name, she would have had to continue taking RMDs each year.

The taxation rules allow withdrawals from an IRA without penalty after the age of 59 ½. Younger spouses under the age of 59 ½ (not always women – I know a woman whose partner is 15 years younger than she is!) should re-title the account “John Doe IRA (deceased July 4, 2012) for the benefits of Jane Doe, beneficiary.” Why? Should the spouse need to take withdrawals before reaching that age of 59 ½ , these withdrawals will be subject to a 10 percent penalty without this change.

When the inheriting spouse turns 59 ½, he or she should re-title the account again in his or her own name. This second renaming allows postponing withdrawals to age 70 ½, rather than taking forced withdrawals at the earlier date when the deceased spouse would have reached 70 ½.

Non-spousal beneficiaries

Richie Rich II left the balance of his retirement funds to his son, Richie III. Richie II deferred taxes by establishing the retirement accounts. Richie III is not certain how to handle this inherited asset but is excited to learn that he can take all of the inherited IRA in a lump sum. Wow. He and his wife can add that swimming pool they have wanted. Richie III finds taking the lump sum tempting, but he should be advised that it is extremely costly in terms of the tax burden it creates. He will pay taxes on the full amount at the time of withdrawal.

The best strategy for Richie III is to leave as much money as possible in the account to continue the tax deferral. Richie III should avoid taking distributions that he doesn’t have to take, thereby paying taxes prematurely.

Richie III must make RDMs in the year following his father’s death. Richie III must consult the IRS Life Expectancy Tables and identify the factor set for the age he turns that year. He divides that factor into the balance of the IRA he inherited as of Dec. 31 of the previous year. This sets the amount of RMD for that year. Each year he repeats the process using the original life expectancy minus one year.

Stretching benefits to grandchildren

Under current law, some families can stretch the benefits of an IRA across generations. For instance, suppose frugal Joe dies at 70 with a traditional IRA which contains $100,000. His daughter, Julie, inherits the IRA when she is 45. Assume the IRA is invested prudently and continues to grow and Julie limits withdrawals to the required amounts and dies at age 75. Funds should be left for her son to inherit the IRA. Of course, the ability to stretch the benefits across three generations, as in this example, is dependent upon the increase in value and amounts of withdrawals.

Seek professional advice

The rules for handling inherited IRAs are complex and subject to change, so those inheriting or gifting a qualified retirement account should consult a knowledgeable professional to advise them on current methods to avoid unnecessary taxation. Be aware that even financial specialists may not be clear on all the rules, so it is crucial to be check out the adviser’s credentials and specific expertise and get more than one opinion if there is any doubt.

Sandra W. Reed is an attorney with Katten & Benson, an Elder Law firm in Fort Worth. She lives in Somervell County, near Chalk Mountain. If you have questions about this column or wish to suggest a topic of interest she may be contacted by phone at (254) 797-0211 or by email at swreed2@yahoo.com.