Tag Archives: Inherited IRAs

IRAs

WHY DOESN’T YOUR WILL OR TRUST MANAGE INHERITED RETIREMENT ACCOUNTS?

For many of us, individual retirement accounts can be one of our major assets.   They include 401(ks), Roth 401(k)s, 403(b)s, Individual Retirement Accounts (IRAs),  Roth IRAs, Keoughs and SEPS.

We spend a lot of time deciding what to invest in and how to make our 401(ks) and IRAs grow while we are living.  Few of us understand the rules and complexities associated with our choice of beneficiaries and their choices when we die.   Rules that are created by the Internal Revenue Service and the custodian of the retirement account.  Rules and choices that have a huge impact on the long term value of a tax deferred retirement account.

If your beneficiaries don’t follow these rules when they establish inherited IRAs, they can lost their ability to stretch the tax deferred benefits available through an inherited retirement account.

The following questions and answers discuss 401(k) and individual retirement accounts (IRAs) retirement laws and the how the choices you and your beneficiaries make impact the tax deferred value of your retirement accounts.

The rules and laws regarding retirement accounts are complex.  We recommend you, or your beneficiaries, visit someone with specialized knowledge about inherited retirement accounts before finalizing your beneficiary choices.

THE RULES
Federal Laws

Q.  What does the Internal Revenue Service (IRS) have to do with inherited retirement accounts?

A.  Your retirement accounts are your self funded pension.  Congress wrote a set of rules which created the ability to set up retirement accounts.  The Internal Revenue Service creates and documents the guidelines on how and when to contribute or withdraw distributions that meets the laws passed by Congress.  m

The rules and regulations your beneficiaries must follow for inherited retirement accounts are not managed by your will or living trust.   They are governed by a series of complex IRS rules dictating the manner and degree to which beneficiaries access the retirement accounts they inherit.  Yes, the same IRS which oversees you federal income tax returns.

Think of these retirement account laws as creating a special will directing what happens to your retirement accounts.  A will you didn’t write.  A will managed by IRS guidelines and new rulings from the IRS on what the guidelines really mean.

Custodian Agreement

Q.  How does your custodian agreement impact what happens with your retirement accounts?

A.  When you open a retirement account, you sign a contract with the custodian.  Your retirement account is then managed according to the terms of the agreement between you and your custodian.  If you are employed and contributing to a 401(k), the custodian is usually your employer.  If you have a self directed IRA account at Charles Schwab, Charles Schwab is the custodian.

Although the IRS provides guidelines on how a retirement account should operate, the custodian agreements may be different from one custodian to another.  You should read the custodian agreement very carefully.

  • You may find the agreement includes language designating a default beneficiary, otherwise known as a “contingent beneficiary”, who inherits your retirement account if (a) your designated beneficiaries die before you, (b) you have designated your estate as the beneficiary, or (c) your designated beneficiaries die at the same time you do.
  • The agreement may also include default language regarding whether your beneficiaries inherit on a per stirpes or per capita basis.  You may find the default provisions don’t match your own beneficiary preferences
  • Although new laws permit non-spouse beneficiaries or 401(k) accounts to set up inherited IRAs, not all 401(k) custodian agreements offer this option.

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PRE-TAX AND POST-TAX RETIREMENT PLANS

Q.   What is a pre-tax retirement plan?

A.  401(ks)sm 403(b)s , Keoughs, and Individual Retirement Accounts (IRAs) are funded with pre-tax contributions.    For example:

  • You earn $10,000 in 2008 and you contribute $1,000 to your retirement account
  • You deduct the $1,000 of retirement contributions from your taxable income
  • You report taxable income of $9,000 on your Form 1040 tax return and you pay income taxes on $9,000.
  • The $1,000 is considered a pre-tax retirement contribution, as you did not pay taxes on the $1,000 contribution you made to your retirement account.
  • You will be required to start taking required minimum distributions at the age of 70 1/2.    Withdrawals will be reported on your 1040 tax return and you will pay applicable taxes.

Q.   What is a post-tax retirement plan?

A.  Roth IRAs, Roth 401(k)s and Roth 403(b) retirement accounts are funded with post-tax contributions.

  • You earn $10,000 in 2008 and you contribute $1,00 to your retirement account.
  • You report taxable income of $10,000 on your Form 1040 tax return and pay income tax on the entire $10,000
  • The $1,000 is considered a post-tax retirement contribution, as you paid taxes on $1,000 of income.  Your retirement contributions were made with money you have left after paying any federal and state income taxes due.
  • You, as the original owner are not subject to any required minimum distributions.   In fact, the earnings in a post-tax retirement plan may grow tax deferred until you die.

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Q. Can you decide when your beneficiaries withdraw the funds they inherit?

A. Unless you set up a trust for managing your retirement accounts, your beneficiaries are in control of when they withdraw their funds.

  • A beneficiary can immediately withdraw the entire balance of your retirement accounts and pay any taxes due.
  • A beneficiary can withdraw the entire amount over a 5 year period and pay any taxes due.
  • A beneficiary can set up an inherited IRA account and stretch the tax deferred nature of your account, maximizing the value of the retirement account for your beneficaries
  • A surviving souse beneficiary can roll over the account into or his her own.

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Q. Are you required to name your spouse as the beneficiary of your retirement account?

A. Federal regulations automatically designate your spouse as the beneficiary of your 401(k) or Roth 401(k) retirement account.  You may not designate another person as the primary beneficiary unless your spouse signs a document approving such a designation.   In some states, the document signed by your wife must be notarized.

If you live in a community property state, you will also need written spousal consent if you, as the owner of a self directed IRA or Roth IRA, want to designate someone other than your spouse as your primary beneficiary.  In some community states, the document signed by your spouse must be notarized.

Fact.  These community states require the consent to be notarized:  Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

Q.  If you list your spouse as your designated beneficiary, can the surviving spouse roll over your account into an account of their own?

A.  If your spouse is the only person you name as a beneficiary, your surviving spouse has the right to roll over your retirement account into theirs.   Onc the roll over is complete, the surviving spouse is listed as the owner of the account.  The surviving spouse inherits the same rights as the original owner of the account.

  • The surviving spouse can name a designated beneficiary who will inherit the account when the surviving spouse dies.
  • The surviving spouse can continue making contributions to the account.
  • The assets continue to grow tax deferred.
  • A 10% penalty is assessed if the surviving spouse withdraws money before the age of 59 1/2.
  • A spouse who inherits an IRA or 401(k) must start taking required distributions (RMD) at the age of 70 1/2 using the IRS Publication 590, Table II life expectancy factor.
  • If the account owner who died was taking RMD, the surviving spouse can withdraw funds necessary to pay the required RMD of the deceased without incurring a 10% penalty.
  • A spouse who inherits a Roth account can decide when they want to start taking withdrawals.

If a surviving spouse is not the sole beneficiary, the surviving spouse and the other named beneficiaries must set up inherited accounts or withdraw all of the funds within 5 years.

Q. Can a surviving spouse elect to stay a beneficiary?

A. Yes   A surviving spouse has the right to stay a beneficiary rather than rolling over an inherited retirement account into theirs.  If they elect to do this, they must set up an inherited account and will have the same rights as all beneficiaries of an inherited retirement account.

The downside of an inherited IRA versus a rollover is the surviving spouse beneficiaries are treated as successor beneficiaries.  Their life expectancy factor is inherited from the life expectancy factor of the surviving spouse, reducing the ability of a young beneficiary to stretch the payout over a long period of time.

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Q. What if someone other than your spouse is the named beneficiary?

A. A beneficiary can elect to immediately withdraw all of the money, or the beneficiary can elect to set up an inherited retirement account.

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Q. What is an inherited retirement account?

A.  An inherited retirement account allows your spouse and any other designated beneficiary to maintain the tax deferred nature of your account.   The length of time the funds can continue to grow tax deferred depends upon the beneficiary’s age when he or she inherited the account.  Some people refer to this as “stretching” the retirement account.

Although the original owner of a Roth IRA is not subject to required minimum distribution calculations, their beneficiaries are.

Q. Can a beneficiary of a company sponsored retirement account set up an inherited retirement account?

A. The rules are different for company sponsored retirement plands and self directed IRAs and Roth accounts.

Until the Pension Reform Act of 2006 was passed, non-spouse beneficiaries o were not allowed to set up inherited IRAs.  Beneficiaries had to comply with the company plan rules, which usually required an immediate distribution of the retirement funds, or allowed the funds to be distributed in a one or two year window.

Under the new Pension Reform Act rules, a non-spouse beneficiary can now roll over the funds into an inherited account.  This right is not a mandatory requirement.  The custodian agreement governing the 401(k) plan you are part of must offer this feature.

Q. What should you know about inherited retirement accounts?

A. The rules for inherited retirements accounts are the same, no matter whether the original account was a 401(k)/IRA or a Roth 401(k)/Roth IRA plan.

  • The name of the original retirement account owner continues to be listed as the owner on the inherited account paperwork.
  • The social security number of the beneficiary inheriting the account is added to the account records.   All distributions will be reported to the IRS using the beneficiary’s SSN.
  • A beneficiary of an inherited account cannot make further contributions to the account.
  • There is no 10% penalty for taking distributions before the age of 59 1/2.
  • If there are multiple beneficiaries, a separate account must be established for each beneficiary by December 31 of the calendar year following your year of death.

Q.  What happens if your designated beneficiary dies before all of the inherited retirement funds are distributed?

A. When the designated beneficiary set up the inherited retirement account, IRS regulations allow the designated beneficiary to name a successor beneficiary,.

  • If the beneficiary dies and funds are still available for distribution, a named living successor beneficiary can continue to take advantage of the stretch payout available to the original designated beneficiary.  The successor beneficiary also inherits the life expectancy factor of the original beneficiary and uses this to calculate their RMDs.
  • The successor beneficiary has the same rights as the original beneficiary.  They can name a successor beneficiary who will inherit the account and the remaining RMD of the original beneficiary.

Q. Will your beneficiaries need to pay income tax on their withdrawals?

A. The beneficiary of an inherited retirement account assumes the same income tax rules as the original account owner.

The beneficiaries of a post-tax inherited retirement account, Roth IRAs and Roth 401(k)s, receive their distributions tax free.

The beneficiaries of a pre-tax inherited retirement account, 401(k)s and IRAs report their distributions as income and pay the applicable federal and state income tax.

Q. What happens if your estate is listed as the beneficiary or the estate becomes the default beneficiary?

A. Naming your estate as the beneficiary of our IRA, or having the estate become the beneficiary because there is no living named beneficiary, has a variety of consequences.

When the beneficiary is the estate, the retirement account becomes a probate asset and is subject to the same delays, costs and processes as other assets that are being probated.

Most custodial accounts provide that if an owner dies without naming a beneficiary, the account beneficiary is the owner’s estate.  In such a case, the account beneficiaries will be the heirs of your estate determined by your will or, if you don’t have a will, state intestate statues.  However, some IRA custodial agreements contain language defining the beneficiary if the estate is the named or default beneficiary.

If the estate is the beneficiary, the beneficiaries lose their right to set up inherited accounts.  They must either withdraw all of the funds within five years or use the life expectancy factor of the original owner of the retirement account.

Q. What happens if you name a minor child as a beneficiary?

A. Minor children cannot manage money or other property until they are legally an adult, which happens when they turn 18 or 21, depending on state laws.  See the section on Minor Children for help on giving property to a minor child.

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Q. Why would you establish a trust as the beneficiary of your retirement account?

A.  Naming an IRA trust as the beneficiary of your retirement accounts provides you with several options not available if you name an individual or your spouse as the designated beneficiary:

  • You can control when a beneficiary can withdraw the funds.  If you want to maximize the value of a stretched retirement account, consider setting up an IRA trust.
  • If the beneficiary is a minor child, the trustee can name a trustee who will manage the money on behalf of the minor child without any involvement of the probate court
  • You may want to control the second inheritance of the account.   If you are in a second marriage, you may want to give your spouse distributions from an inherited retirement account while he or she is living, but control who inherits the accounts when he or she dies.  In contrast, if you name your spouse as the primary beneficiary, the spouse will also inherit the right to determine who receives the inherited account when he or she dies.

Be sure and consult an attorney with knowledge in this area.  The IRA trust needs special language identifying the beneficiaries.  If the IRS does not believe the trust meets its requirements for naming beneficiaries, the trustee must take a lump sum distribution of the assets or pay out all of the funds within a five year period.

Naming a trust as the beneficiary is not the same as transferring your retirement account into the name of the trust.  DO NOT TRANSFER THE TITLE ON YOUR RETIREMENT ACCOUNT INTO A TRUST WHILE YOU ARE LIVING.   Such action may cause the account to lose its tax-deferred status and you would need to report the transfer as income and pay any necessary taxes.

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Q. Is your retirement account part of your taxable estate?

A. Your retirement accounts are part of your federal taxable estate.   If your estate is subject to the estate tax, understand how these taxes will be paid.   Discuss the opportunities to use the funds in your retirement accounts to fund life insurance or annuities to offset the costs of estate taxes.

Wherever possible, try to save the funds in the retirement accounts from being used to pay estate taxes.  Talk with your beneficiaries before you die.  Understand how your estate will pay estate taxes and keep the tax tax deferred advantage of your retirement accounts for your heir.

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Inherited IRAs and Inherited 401(k)s

You and other Americans like you have accumulated an estimated $11 trillion of wealth in retirement plans.  That’s $2 trillion more than the total market value of all publicly traded U.S. stocks and significantly greater than the $4.5 trillion in total bank deposits reported by the Federal Reserve.  Source: Judy Diamond, Journal of Financial Service Professionals, July 2003.

For many of us, individual retirement accounts can be one of our major assets.  They include 401(k)s, 403(b)s, Roth Individual Retirement Accounts, self directed Individual Retirement Accounts, Keoghs and SEPs.

We spend a lot of time deciding what to invest in and how to make our 401(k)s and IRAs grow while we are living.  Few of us understand the rules and complexities associated with our choices of beneficiaries and their choices when we die.  These choices have a huge impact on the long term value of your tax deferred retirement account.

The rules regarding the withdrawal and distribution of inherited retirement accounts are complex.  If your beneficiaries don’t correctly follow the rules in establishing inherited IRAs, the ability to stretch the tax deferred benefits from the account will be lost.  If they don’t pay any necessary required minimum distributions (“RMDs”), they may be subject to a 50% IRS penalty.

What rules manage your retirement accounts?
What is the difference between a pre-tax and a post-tax retirement plan?
Can you decide when your beneficiaries will withdraw the funds they inherit?
How can you and your beneficiaries maximize the value of their inherited retirement accounts?
Why would you establish a trust as the beneficiary of your retirement account?
Why should you not name your “estate” as the beneficiary?

Q.  What rules manage your retirement accounts?
A.  These rules include:

Federal laws:

Your retirement accounts are your self funded pension.  Congress created the rules on how your retirement accounts work.  The Internal Revenue Service wrote guidelines on how and when to contribute or withdraw distributions in accordance with federal guidelines.

The rules and regulations your beneficiaries must follow for inherited retirement accounts are not managed by your will or living trust.  They are governed by a series of complex Internal Revenue Service (IRS) rules dictating the manner and degree to which beneficiaries access the retirement accounts they inherit.  Yes, the same IRS which oversees your federal income tax returns.

Think of these retirement account laws as creating a special will directing what happens to your IRA assets.  A will you didn’t write.  A will managed by IRS guidelines and new rulings from the IRS on what the guidelines really mean.

Understanding your beneficiary options and the consequence on the long term tax deferred value of your retirement accounts is essential.  If you make a mistake, or your beneficiary makes a mistake, the IRS penalties are harsh and costly.

State laws:

Different states have different laws regarding the process necessary if you want to name someone other than your spouse to inherit your retirement accounts.  Further, states differ in their treatment of the income generated from IRAs.

Custodian agreement:

When you open a retirement account, you sign a contract with the custodian.  Your retirement account is then managed according to the terms of the agreement between you and your custodian.  If you are employed and contributing to a 401(k), the custodian is usually your employer.  For example, if you have a self directed IRA account at Charles Schwab, Charles Schwab is the custodian.

Although the IRS provides guidelines on how a retirement account should operate, the custodian agreements may be different from one custodian to another.  You should read the custodian agreement very carefully.

  • You may find the agreement includes language designating a default beneficiary, otherwise known as a “contingent beneficiary”, who inherits your retirement account if (a) your designated beneficiaries die before you, (b) you have designated your estate as the beneficiary, or (c) your designated beneficiary dies at the same time you do.
  • The agreement may also include default language regarding whether your beneficiaries inherit on a per stirpes or per capita basis.  You may find the default provisions don’t match your own beneficiary preferences.
  • Although new laws permit non-spouse beneficiaries of 401(k) accounts to set up inherited IRAs, not all 401(k) custodian agreements offer this option.

We have provided a few questions and answers about naming beneficiaries for retirement accounts and inherited retirement accounts in the charts below.

We highly recommend that you, your designated beneficiary and your executor or trustee visit someone with specialized knowledge about inherited retirement accounts before finalizing your beneficiary choices and before your beneficiaries open up their own inherited retirement accounts.  Once a beneficiary has made a choice, the IRS generally does not allow you to go back.

Your beneficiary has the choice to immediately withdraw the money or stretch the payout of your retirement account to successor beneficiaries.  The longer your retirement account can continue to grow in its tax-deferred state, the bigger its benefits.  When making a choice between a 401(k) or a Roth IRA, be sure to consider the after death value to your beneficiaries.

Before finalizing your choice of a Roth IRA versus other choices or selecting your beneficiaries, visit www.diesmart.com.  You can see the long term value of these accounts based upon the taxable nature of the distributions, your choice of beneficiaries and their life expectancy factor.

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Q. What is the difference between a a pre-tax and a post-tax retirement plan?
A. The primary difference is whether they are funded with pre-tax money or post-tax money.

Pre-tax retirement plans.

401(k)s, 403(b)s and Individual Retirement Accounts (IRA) are funded with pre-tax contributions.  You earn $10,000 in 2008 and you contribute $1,000 to your retirement account.  You deduct the $1,000 of retirement contributions from your taxable income.  You report taxable income of $9,000 on your Form 1040 tax return and you pay income taxes on $9,000.  The $1,000 is considered a pre-tax retirement contribution.

At the age of 70 1/2, the account owner must begin taking distributions from the account, referred to as the Required Minimum Distribution (RMD).

The distributions are reported as ordinary income on your 1040 tax return and any applicable federal and state income taxes must be paid.

Post-tax retirement plans.

Roth IRAs, Roth 401(k) and Roth 403(b) retirement accounts are funded with post-tax contributions.  You make $10,000 a year in 2008 and you contribute $1,000 to your retirement account.  You report taxable income of $10,000 on your Form 1040 tax return and pay income tax on the entire $10,000.  Your retirement contributions were made with money you had left after paying any federal and state income taxes due.  The $1,000 is considered a post-tax retirement contribution.

The original account owner is not subject to any required minimum distributions.  In fact, the earnings in a post- tax retirement plan may grow tax deferred until the owner dies.

The distributions are not considered as income and no federal income tax is due on the distributions.

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Q. Can you determine when your beneficiary withdraws funds from his inherited retirement account?
A. Unless you set up a trust for managing your retirement accounts, your beneficiaries are in control of when they withdraw the funds.

Option 1: A beneficiary can immediately withdraw the entire balance of your retirement accounts and pay any taxes due.

Option 2: A beneficiary can withdraw the entire amount over a 5 year period and pay any taxes due.

Option 3: A beneficiary can set up an inherited IRA account and stretch the tax deferred nature of your accounts.

Option 4: A surviving spouse beneficiary can roll over the accounts into their own.

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Q.  How can you and your beneficiaries maximize the value of their inherited retirement account?
A.  Your beneficiary may have the option of setting up an inherited IRA account and “stretching” the tax-free distribution of the funds over a period of time, referred to by the IRS as his or her “life expectancy factor”.   Your beneficiary can name a “successor beneficiary”, someone who will inherit the same rights and privileges as the original beneficiary should the original beneficiary die.

Q.  Why would you name a trust as the beneficiary of a retirement account?

A. You can control when a beneficiary can withdraw the funds.

  • If you want to maximize the value of a stretched IRA, consider setting up an IRA trust.  The instructions in the trust will provide that the distribution of income from your IRA to the beneficiaries will be stretched.  The beneficiaries cannot immediately cash out the account, which is then held in trust.  If you just name an individual as the beneficiary, that individual can elect whether to immediately cash out the account or set up an inherited account.
  • If the beneficiary is a minor child, the trustee can name a custodian who will manage the money on behalf of that child.
  • You may want to control the second inheritance of the account.  If you are in a second marriage, you may want to give your spouse distributions from an inherited retirement account while he or she is living, but control who inherits the accounts when he or she dies.  In contrast, if you name your spouse as the primary beneficiary, the spouse will also inherit the right to determine who receives distributions when he or she dies.

Be sure and consult an attorney with knowledge in this area.  The IRA trust needs special language identifying the beneficiaries.  If the IRS does not believe the trust meets its requirement for naming beneficiaries, the trustee must take a lump sum distribution of the assets or pay out all of the funds within a five year period.

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Q.  Why should you not name your “estate” as the beneficiary of a retirement account?
A. Naming your estate as the beneficiary of your IRA, or having the estate become the beneficiary because there is no living named beneficiary, has a variety of consequences.

A named beneficiary has an immediate right to distribute the retirement assets upon your death.  When the beneficiary is the estate, the account is a probate asset and will be subject to the same delays, costs and processes as other assets that are being probated.

Most custodial agreements provide that if an owner dies without naming a beneficiary of their account, the account beneficiary is the owner’s estate.  In such a case, the account beneficiaries will be the heirs of your estate determined by your will or, if you don’t have a will, state intestate statutes.  However, some IRA custodial agreements contain language that, in the absence of a named beneficiary, upon the owner’s death the account money belongs to a spouse, then to surviving children, before the estate becomes the beneficiary.

The beneficiaries determined by a will (or laws of intestate succession) lose their right to “stretch” the payout of the retirement account. They must either withdraw all of the funds within five years or use the life expectancy factor of the original owner of the retirement account.

If the beneficiary of a traditional IRA is determined by a will or intestate succession laws, these rules apply:

  • If the deceased original owner of the account was over the age of 70 1/2 and was already taking required minimum distributions, the beneficiary determined by the owner’s will (or state intestate succession laws) assumes the life expectancy factor of the original owner based on the IRS Single Life Expectancy Table.
  • If the owner dies at the age of 80, the new beneficiary inherits a life expectancy factor of 10. The beneficiary must withdraw all of the money within 10 years of the year of the original owner’s death.
  • If the deceased original owner was under the age of 70 1/2 and was not taking required minimum distributions, the new designated beneficiary must withdraw all of the funds by the end of the fifth year following the year of the owner’s death.  No distribution is required for any year before that fifth year.

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