Avoiding Inherited IRA Problems

Investing Daily Article of the Week

by Bob Carlson, Investing Daily

Inherited IRAs are the focus of some of the saddest stories in estate planning. An IRA owner takes the time to arrange things so that the IRA will pass to the beneficiaries at the lowest tax cost and the heirs can stretch the IRA to last for years. Unfortunately, the heirs fall into one of several traps in the tax law and end up having to pay maximum income taxes on the IRA over a short time. These adverse consequences easily could have been avoided.

Your IRA beneficiaries need as much advice when inheriting an IRA as you needed setting up your estate plan, and perhaps more. The main problem is that the tax code requires some precise wording and actions. Another problem is that the IRA custodian isn’t in the business of advising your beneficiaries or helping them choose the option that’s in their best interests. Most custodians believe their job is to do whatever the beneficiaries tell them to do, or what they seem to be saying.

Here are some common issues that often lead to avoidable problems.

• An inherited IRA needs to be retitled. That’s a legal move that should be very simple. But most beneficiaries aren’t lawyers. Too often they contact the IRA custodian and use imprecise language. They aren’t clear about their intentions. The result is that the IRA custodian distributes the entire IRA to the beneficiaries.

Once the inherited IRA is distributed, the beneficiaries have to include the distribution in gross income. Unlike your own IRA, there is no 60-day grace period in which the distribution can be returned to the IRA or deposited in another IRA to avoid income taxes. When a distribution is made from an inherited, whether intentionally or by an error, the potential for continuing tax deferral is over. The beneficiary owes taxes on the distribution and has available only the after-tax amount.

The beneficiary has to clearly 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 is not being requested. 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 the beneficiaries. A common phrasing is: Max Profits, deceased, FBO Hi Profits.

• Often the beneficiary of an inherited IRA wants to transfer the IRA to the financial institution where the beneficiary has other accounts. That’s a reasonable and normal request. But the beneficiary has to understand that certain requirements have to be met before the transfer can be made.

An inherited IRA can be transferred from one custodian to another only if the legal titles of the two IRAs match. So, IRA has to be changed to a properly-titled inherited IRA at the custodian where it currently is. Only after that can the beneficiary named in the inherited IRA’s title request that the IRA be rolled over to another financial institution.

Once again, after the title is changed, when requesting the transfer be clear that you want a trustee-to-trustee transfer. The best approach is to contact the firm to where you want the inherited transferred and open a new IRA in the same name as the inherited IRA. Then request that firm to have the original IRA transferred to them. Remember with an inherited IRA only trustee-to-trustee or custodian-to-custodian rollovers are valid. If you take a check from the inherited IRA, it is taxable and you can’t return it to the IRA or deposit it in another IRA.

• Beneficiaries need to know that the retitling process isn’t automatic. The IRA custodian has to be sure that the original IRA passed away and that the person contacting them is the beneficiary entitled to the IRA. Each IRA custodian will have different requirements, but in general a beneficiary needs to provide proof of the owner’s passing and of his or her own identity. Then, the beneficiary will have to complete and sign the usual paperwork of the custodian.
• An important exception to some of these rules is when the beneficiary is the owner’s surviving spouse. The surviving spouse can, after establishing his or her bona fides with the custodian, have the inherited IRA rolled over into his or her own IRA, either a new one or an already-existing one. But only surviving spouses have this option.
• Required minimum distributions must begin from an inherited IRA by Dec. 31 or the year following the owner’s death. Many beneficiaries don’t understand that and pay the penalty of 50% of the amount that should have been distributed, plus the income taxes. The RMD schedule varies depending on the age of the deceased owner. Details are in IRS Publication 590.

Author’s Note: 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 web site at www.RetirementWatch.com by clicking on the “Bob’s Library” tab.