Non-spousal Inherited IRA Traps

When people ask me what I do for living, I tell them that I am a wealth preservation counsel. Then they usually say, “oh, you are an estate planner.” No, a wealth preservation counsel. Wealth preservation is more than just estate planning. It encompasses several topics including estate planning, wealth management, asset protection and retirement distribution planning.

With the rising estate tax exemption ($5.43 million per person in 2015) and the new portability rules, which allow a surviving spouse to also use any unused estate tax exemption from their spouse’s estate, estate planning has become less of an issue for most people. People should still have a will and any medical directives that they wish to have.

I am Scotch-Irish, so I like to explain wealth preservation using the Scottish saying “get what you can and keep what you have – that’s the way to get rich.” And fortunately, there are several easy and effective strategies that anyone can use to protect their wealth.

One of the most common mistakes people make is with regard to non-spousal inherited individual retirement accounts (IRAs). I usually get a couple of call each month from people with questions about receiving and managing non-spousal inherited IRAs. I always enjoy such calls, as it means someone is taking the time to avoid disasterous tax consequences and make the most of the inherited IRA.

Surviving spouses have a lot more options with regard to their deceased spouse’s IRA. The proper choice usually depends on the specific situation and the spouse’s needs. In most cases, the worst choice is to simply take a lump sum distribution of the entire IRA, as it results in immediate taxation on the full amount, with the proceeds taxed as ordinary income instead of the more favorable capital gains tax.

For non-spouses, there are less options and extremely specific rules that must be followed in order to prevent immediate taxation of the full IRA account. The non-spouse can also take a lump sum distribution of the entire account, but again, that is often the worst choice due to the immediate taxation issue.

The better choice is generally to preserve the tax-deferral benefits of the inherited IRA. In order to do so, the non-spouse must transfer the IRA account to a “beneficiary IRA”  account by means of a “direct trustee to trustee” transfer. It is crucial that the transfer be accomplished without the non-spousal beneficiary ever receiving the money. If the non-spousal beneficiary does receive the money, the full amount is immediately taxable and the benefit of tax-deferral is obviously lost. The non-spousal beneficiary is not allowed to place the money back into the original IRA to “correct” the mistake.

One of the most common mistakes occurs in properly setting up the non-spousal inherited IRA. The non-spousal beneficiary is not allowed to set up the inherited in their own name or to rollover the inherited IRAs assets into another existing IRA account. If they do so, it is considered to be a receipt of the proceeds, resulting in immediate taxation of the entire account.

The non-spousal beneficiary account must be set up in the name of the deceased and properly referencing the fact that the account is a beneficiary account. Do not assume that your financial adviser, stockbroker and/or bank knows how to do this properly and will do so! The IRS has the power to grant relief if the account is set up improperly and the non-spousal beneficiary was totally innocent of any error. But this is not a given, and the trend seems to be less relief and allowing the beneficiary to sue the party who made the mistake.

I tell people to require the third party handling the transfer to provide a copy of the paperwork before processing the actual transfer. While there are various methods of properly titling the account to show the required information, one acceptable method would be “John Doe IRA, deceased, FBO Jim Watkins, beneficiary.” Again, show owner’;s name, indicate that they are deceased, in indicate non-spousal beneficiary by name and status.

Non-spousal inherited IRA beneficiaries also have one other option with regard to an inherited IRA. A beneficiary can disclaim, or refuse the inherited IRA. The most common reason for disclaiming an inherited IRA would be for tax reasons, when the the non-spousal beneficiary does not need the IRA’s assets. Disclaiming beneficiaries need to understand that if they disclaim, they do not get to decide who receives the disclaimed IRA. The IRA would pass in accordance with any the terms of the beneficiary designation document or in accordance with applicable laws of descent.

The goal with inherited IRAs is usually to delay, or “stretch,” the taxation of the IRA for as long as possible. Done properly, the benefits of tax deferral can be stretched out over decades. It should be noted, however, that the federal government is reportedly considering eliminating the “stretch” option and requiring non-spousal IRA beneficiaries to payout their inherited IRA within five-years of their inheritance of same.

 

There are various rules with regard to required distributions from inherited IRAs, depending primarily on whether there is just one or multiple beneficiaries. I’m not going to go over all the rules, as it would probably just confuse the reader. The key to obtaining the maximum benefit of tax deferral and minimizing required annual distributions is to take whatever action is necessary to ensure that each beneficiary has a separate IRA beneficiary account, thereby allowing them to use their own life expectancy in computing annual required distributions.

These are some of issues that should be considered by any non-spouse inheriting an IRA. As I mentioned, several possible changes are being considered by the government that would require eliminate “stretch” IRAs and require the distribution of non-spousal IRAs at a much faster rate. The bottom line is that if you receive a non-spousal inherited IRA, do not do anything with the IRA account until you have spoken with someone who is both knowledgeable and experienced with these accounts in order to avoid disastrous tax and wealth management consequences.

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