You put effort and resources into accumulating your IRA.
As a result, assets in those accounts are among your estate’s most valuable. In taking the time to include IRAs in your estate plan, you are seeking to pass along those assets to your loved ones at the lowest tax cost.
You also probably planned for your loved ones to benefit from a Stretch IRA to allow the wealth and tax-deferred compounding to last for a long time. Unfortunately, in too many families the beneficiaries mess up all that planning.
It doesn’t have to happen, but it frequently does. Here is a way to ensure your wealth accumulation and planning don’t go to waste. Take precautions to help your loved ones avoid common mistakes with inherited IRAs and tax-law traps.
Most estate owners and their beneficiaries don’t realize that heirs usually need as much advice when inheriting an IRA as you required to set up your estate plan. Among the trickiest rules regarding IRAs are those involving inherited IRAs. The IRS requires precise compliance with its rules. Otherwise, inherited IRAs face taxes and penalties.
The first thing your heirs need to know is that the IRA custodian, or trustee, isn’t in the business of providing tax or financial advice to your beneficiaries. The custodian also isn’t going to help them decide which option is in the beneficiaries’ best interests.
The custodian is there to process the transactions the beneficiaries request or that the custodian thinks they requested. That last point is important. Beneficiaries need to be precise in their requests. If a beneficiary asks for one thing but the custodian thinks the request was for something else, the beneficiary can be stuck with whatever actions the custodian takes.
Here are common oversights, mistakes and pitfalls involving inherited IRAs.
The new title of the IRA has to have the names of both the original owner and the beneficiary or beneficiaries and state that it is being held for the benefit of (or “FBO”) the beneficiaries. A common phrasing is: Max Profits, deceased, FBO Hi Profits. Each custodian has its own preferred variation of the language.
A common mistake is for a beneficiary to give the custodian the impression that the IRA’s title should be changed to the beneficiary’s name or rolled over to the beneficiary’s IRA. Either action is treated as a distribution of the entire IRA. The beneficiary clearly has to tell the custodian that it is an inherited IRA and he or she only wants the title changed to reflect that. The beneficiary should be clear that a distribution or rollover is not being requested.
With an inherited IRA there is no 60-day grace period in which a distribution can be returned to the IRA or deposited in another IRA to avoid income taxes. When a distribution is made from an inherited IRA, whether intentionally or by an error, the potential for continuing tax deferral is over. The beneficiary owes taxes on the distribution.
An inherited IRA can be transferred from one custodian to another only if the legal titles of the two IRAs match. The IRA first has to be changed to a properly titled inherited IRA with the current custodian, as already discussed. Only after that change can the IRA be safely rolled over to another financial institution to an IRA with the same legal title that now is on the inherited IRA.
If the beneficiary is impatient and tries to transfer the inherited IRA to an existing IRA in one move, the transfer likely will be treated as a distribution.
Once again, the beneficiary must know that with an inherited IRA the 60-day rollover rule doesn’t apply. The rollover must be a trustee-to-trustee transfer.
The best approach is for the beneficiary first to contact the current IRA custodian and have the legal title changed to reflect that it is an inherited IRA. Then, after the title is changed, contact the firm where he or she would like the IRA to end up. Open a new IRA with the same title as the inherited IRA. Then request that custodian to have the original IRA transferred to the new IRA.
This is called a “fresh start” IRA, because the surviving spouse then can treat it as though it were his or her IRA all along. The surviving spouse can name new beneficiaries, and required minimum distributions are taken based on his or her life expectancy.
But only surviving spouses have this option.
Details are in IRS Publication 590. Many beneficiaries don’t know about RMDs and are hit with both income taxes and a penalty of 50 percent of the amount that should have been distributed.
Beneficiaries can learn these and other details about inheriting IRAs through my report, Bob Carlson’s Guide to Inheriting IRAs. It is available on the website at www. RetirementWatch.com. Click on “Bob’s Library” after rolling over the “About Bob Carlson” tab.
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— Bob Carlson
Robert C. Carlson is the author of the book “The New Rules of Retirement” and editor the popular retirement newsletter, Retirement Watch.