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What IRA Owners Need to Know About Beneficiaries - Episode 23 Thumbnail

What IRA Owners Need to Know About Beneficiaries - Episode 23

There are several nuances when it comes to inheriting the assets of an IRA. This depends on the relationship of the beneficiary to the IRA owner, whether the IRA was funded with pretax or after-tax money, and whether the account owner was required to take minimum distributions.

I will touch on some of those nuances here as a guide of things to think about when it comes to planning your legacy. However, please consider talking to an estate attorney about your specific situation.

Listen to Episode 23 Here:


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Review of Beneficiaries

It’s very important to have your beneficiaries set up properly and that you review this frequently since life happens, and things change.

Let’s start with a brief review of beneficiaries. A beneficiary inherits the proceeds of a life insurance policy or the assets in a qualified retirement plan or trust. This happens outside of a will. 

Other bank and investment accounts would generally pass to beneficiaries through a will and must go through a time-consuming probate process, unless these accounts have a designated POD or TOD. A POD is a beneficiary named as Payable on Death for bank and credit union accounts and a TOD is for Transfer on Death of stocks, bonds, and brokerage accounts.

You could designate one or more relatives or non-relatives, a charity, or a trust as a beneficiary. Please review the benefits of each beneficiary designation with an estate attorney. If no beneficiary is named, the account will be part of the owner’s estate, and therefore, subject to probate.

Inheriting an IRA

Generally, when an IRA owner dies, the IRA assets will be transferred to a new inherited IRA in the name of the original IRA owner for the benefit of the beneficiary. The beneficiary cannot make contributions or roll money out of an inherited IRA.

The tax treatment of the inherited IRA will depend on if the original IRA was funded with pretax money (i.e., a traditional IRA) or after-tax money (i.e., a Roth IRA).

If the original IRA was funded with pretax money, the heir will have to pay income taxes in the year money is withdrawn from the inherited IRA based on his or her own income tax rate.

If the original IRA was funded with after-tax money, the heir will not have to pay income taxes on withdrawals. This is a huge benefit of Roth IRAs, which we are big fans of at my firm and have discussed quite a bit in previous podcasts.

10-year Rule for Inherited IRAs

Under the SECURE Act, effective January 1, 2020, inherited IRA assets have to be paid out to most beneficiaries within 10 years of inheritance.

Before the SECURE Act, required distributions could be stretched out over the beneficiary’s remaining life expectancy. However, the SECURE Act eliminated this Stretch IRA.

When your children are the heirs, this leads to a high probability that they will have to take distributions during what are likely to be peak earning years for them, and they would have to pay very high tax rates on the legacy assets. 

Inherited Roth IRAs also have to be withdrawn within 10 years, but since they are tax-free, they won't increase the beneficiary's tax liabilities. 

This alone makes Roth conversions a very key tool for legacy planning. As I’ve mentioned previously this year, I believe we are in the Golden age of Roth IRA conversions since I don't believe tax rates are going to go lower. And why wouldn’t you want to pay the lowest tax rate you can throughout your lifetime! 

Certain Eligible Beneficiaries

There are certain eligible beneficiaries that can still take distributions over their lifetime following the old rules prior to the SECURE Act, including the IRA owner’s spouse, an individual not more than 10 years younger than the IRA owner, and a disabled or chronically ill individual.

In addition, the 10-year withdrawal period for a minor child (but not a grandchild) does not begin until after the child turns 18.

A Spouse as a Beneficiary

An IRA owner’s spouse has a few options when it comes to inheriting an IRA.

  1. The spouse can treat the IRA has their own by becoming the new owner and assigning beneficiaries and following his or her own age requirements for contributions, withdrawals and required minimum distributions (RMDs).
  2. The spouse can roll the account into their own existing IRA or other retirement account within 60 days.
  3. The spouse can remain the beneficiary on the account.

By remaining a beneficiary on the account, the distributions the surviving spouse receives from the IRA that are not required distributions can be rolled into the surviving spouse’s own IRA within 60 days. This is true even if the spouse is not the sole beneficiary of the IRA.

In addition, an older spouse could choose to delay required minimum distributions (RMDs) until the IRA owner would have turned 72. Or a younger spouse could choose to take the RMDs when the IRA owner would have turned 72 and not be subject to the 10% early withdrawal penalty even if he or she has not reached age 59 ½.

Non-spouse beneficiaries cannot treat the IRA as their own and cannot roll the IRA over into their own account. A non-spouse beneficiary could do a trustee-to-trustee transfer to an IRA in the name of the deceased IRA owner for the benefit of the beneficiary.

Non-designated Beneficiaries

A non-designated beneficiary is a nonperson entity such as an estate, a charity, or a trust (generally) that is named as an heir. A non-designated beneficiary would have up to 5 years to withdraw the balance of an IRA if the IRA owner was under age 72, the age at which RMDs are required.

If the IRA owner was over age 72, the non-designated beneficiary may continue to take out the RMDs over what would have been the IRA owner’s remaining life expectancy. This allows the most funds to continue to grow tax-deferred.  

Required Minimum Distributions (RMDs)

For inherited IRAs in which the original owner was required to take RMDs, the beneficiary must take an RMD in the year of the owner’s death if the RMD was not satisfied for that year.

During the 10 years after death, the designated beneficiary may withdraw any amount as long as the full amount is withdrawn by the end of the 10th year after death.

No RMDs are required for a Roth IRA except to fully liquidate the account by the end of the 10th year after death.

5-year Rule for Roth IRAs

A Roth IRA has a 5-year waiting period after the first contribution before the earnings can be withdrawn tax free (assuming you have reached age 59 ½). You can always withdraw your own contributions from a Roth IRA anytime without penalty. The 5-year period starts January 1 of the year the first contribution was made. 

This 5-year rule also comes into play when inheriting a Roth IRA. If the IRA owner dies before the Roth IRA has been opened for 5 years, any earnings withdrawn before the 5-year rule is satisfied will be subject to income tax.

Bottom Line:

As you can see, there is a lot to think about when considering the legacy of your IRA assets.

You need to pay attention to your designated beneficiaries because how and when they receive assets can have large implications on your estates tax liabilities and their lifetime income tax liabilities. 

I encourage you to speak with an estate attorney about your specific situation.

Sources:
https://www.definefinancial.com/blog/inherited-ira-rules-retirement-beneficiary/
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
https://investor.vanguard.com/inherit/ira-rmd
https://www.investopedia.com/not-designated-beneficiary-definition-5025735
https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

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