As the baby boomers enter their sunset years, many of them will use traditional Individual Retirement Accounts (IRA) to support themselves in retirement. For a large number of boomers, traditional IRAs will likely hold a significant portion of their wealth at death. According to a January 2017 report by the Investment Company Institute, approximately 48.9 million U.S. households own IRAs, representing a collective $5.4 trillion in assets (“Appendix: Additional Data on IRA Ownership in 2016,” ICI Research Perspective, http://bit.ly/2HeuQzj). Among U.S. households, approximately 25.5% hold traditional IRAs, and 39% of all IRAs are owned by baby boomers. Estimates project that the average U.S. 65-year-old is expected to live another 19.4 years; thus, in the next two decades, a substantial amount of assets will be disbursed from IRAs owned by baby boomers (“Mortality in the United States,” 2015, NCHS Data Brief, December 2016, http://bit.ly/2JckS1R). As a result, CPAs can expect an increase in questions from clients about the tax and estate consequences of IRAs.
Although the tax consequences for IRA distributions during a taxpayer’s lifetime are relatively straightforward, distributions from inherited traditional IRAs present a number of questions. Among them are the following:
- Can beneficiaries roll over, withdraw, or treat the plan assets as their own?
- If so, when?
- Is there a required minimum or maximum distribution for beneficiaries?
- Which inherited IRA distributions are taxable?
This article will provide an overview of the requirements, limitations, and tax consequences of withdrawals and rollovers from inherited traditional IRAs. Note that although distributions to Roth IRA owners are beyond the scope of this article, beneficiaries of these plans may be subject to certain distribution rules.
Required Minimum Distributions
Generally, when owners of a traditional IRA reach age 70½, they must take required minimum distributions (RMD) based on their life expectancy [Internal Revenue Code (IRC) section 401(a)(9)(A)]. RMDs are mandatory withdrawals that the owner must take from the IRA each year and taxable upon receipt by the owner as ordinary income. If the full amount of the RMD is not taken, the owner may face a 50% penalty on the funds that were not removed from the account [Treasury Regulations sections 54.4974-1(a)–(b), 1.408-2(b)(6)(v)]. These rules ensure that IRA funds do not escape income taxation indefinitely.
When a deceased owner passes an IRA to her beneficiaries, the beneficiaries may be required to withdraw similar RMD amounts as well. There is no maximum on the amount that beneficiaries may withdraw, and there is no penalty for withdrawal [IRC section 72(t)(2)(A)(ii)]; however, they must at least withdraw the full RMD amount each year [Treasury Regulations section 54.4974-1(a)]. Similar to owner distributions, beneficiary withdrawals are taxed as ordinary income, including any RMD.
CPAs should note that the individual’s specific facts and circumstances should dictate their recommendations for RMD options. The primary consideration for these options is whether the beneficiary of the IRA is a spouse or a nonspouse beneficiary. Other factors influencing the recommendations are 1) the age of the beneficiary, 2) the individual’s desire for accumulation of tax deferred funds, 3) the individual’s monetary needs, 4) the value of the IRA, 5) administrative convenience, and 6) the rules of the IRA custodian.
Spouses who inherit an IRA generally have three options: 1) treat the inherited IRA as their own, 2) roll over the funds, or 3) treat themselves as a beneficiary. If the spousal beneficiary treats the IRA as her own, she is free to contribute amounts to the IRA. The spouse will also be allowed to make deductible contributions to the plan and will be subject to a 10% penalty upon an early withdrawal [Treasury Regulations section 1.408-8(A-5) and IRC section 72(t)(1)]. Furthermore, the spouse will be subject to RMD requirements upon reaching the age of 70½ [Treasury Regulations section 1.408-8(A-5)(a) and IRC section 401(a)(9)(A)].
In order to make an election to treat the IRA as her own, the spouse must generally be the sole designated beneficiary of the IRA and must have an unlimited right to withdraw funds from the IRA; she can treat the IRA as their own by simply redesignating the account in her name [Treasury Regulations section 1.408-8(A-5)(b)]. If the spouse does not make an affirmative election, she may still be considered the owner of the IRA if 1) she makes any contributions to the IRA or 2) she does not take an RMD that would have been required of her for that year [Treasury Regulations section 1.408-8(A-5)(b)(1)-(2)]. A qualifying spouse can elect to treat the IRA as her own any time after the owner’s death [Treasury Regulations section 1.408-8(A-5)(a)]. The requirements for determining whether a beneficiary is designated are found in Treasury Regulations section 1.401(a)(9)-4.
When a deceased owner passes an IRA to her beneficiaries, the beneficiaries may be required to withdraw similar RMD amounts as well.
Note that if a spouse elects to treat the IRA as her own in the first year after the owner’s death, she must take any RMD that would have been required of the deceased for that year [Treasury Regulations section 1.408-8(A-5)(a)].
One advantage of a sole designated spouse treating the account as her own is that this option potentially creates the longest tax-deferred treatment of the funds, since the spouse is not required to take any RMD until she reaches the age of 70½. (A disadvantage of this option is that it is not available to spouses who are not sole designated beneficiaries.) In addition, this option may not be suitable for individuals who already have several IRA accounts, or who will need access to the funds in the foreseeable future.
The second option for spouses is to roll over the funds from an inherited IRA to another IRA; this can be done even if the spouse is not the sole designated beneficiary [Treasury Regulations section 1.402(c)-2(A-12)(a); Publication 590B]. The spouse must, however, roll over the assets to the new IRA within 60 days of the distribution. The spouse may not roll over any portion of a distribution that constitutes an RMD [Treasury Regulations section 1.408-8(A-4)(b)]. Note also that, for the purposes of spouses who roll over distributions of inherited IRAs, the rollover rules of IRC section 402 “apply to such distribution in the same manner as if the spouse were the employee.”
The advantage of rolling over the funds is that it provides tax deferral to spouses even if they are not sole designated beneficiaries. In addition, this option is also more administratively convenient for spouses who already own one or more IRA accounts. Like spouses in the first option, however, an individual under age 59½ will generally be unable to access the funds without paying a 10% penalty.
The third option is that a spouse may elect to be treated as a beneficiary. The advantage of this election is that it provides relief to spouses under age 59½ who wish to access the IRA funds in the foreseeable future. Advisors should note, however, that the RMD tables for IRA owners are generally more favorable than the RMD tables for beneficiaries, especially if both spouses are close to 70½. In addition, other variables such as the investment market, net present value calculations, and family circumstances may influence this decision. The rules for spouses treated as beneficiaries are discussed in more detail below.
Nonspousal Beneficiaries and Spouses Electing to be Treated as Beneficiaries
The application of the inherited IRA rules for nonspousal beneficiaries depends upon whether the decedent died before or after taking any RMD. If the decedent died after the RMD payments began, then the beneficiary must take RMD payments based on the longer of the decedent’s life expectancy or the beneficiary’s life expectancy [IRC section 401(a)(9)(B); Treasury Regulations section 1.401(a)(9)-5(A-5)(a)(1)]. Note that if the decedent does not have a designated beneficiary, the RMD is calculated using the decedent’s life expectancy.
If the decedent died before RMD payments began, RMD amounts will be based on either a life expectancy rule or a five-year rule [IRC section 401(a)(9)(B)(ii-iii)]. Under the life expectancy rule, a beneficiary will receive RMD payments based on her own life expectancy [IRC section 401(a)(9)(B)(iii)(II)]. In order to qualify for life expectancy payments, however, the beneficiary must be a designated beneficiary of the plan, take annual payments over her lifetime, and begin taking distributions by the end of the calendar year following the year of death [IRC section 401(a)(9)(B)(iii)]. Note that distributions to a sole designated beneficiary spouse who chooses to be treated as a beneficiary do not have to begin until December 31 of the year that the decedent would have reached age 70½ [Treasury Regulations section 1.401(a)(9)-3(A-3)(b)].
The other option available to nonspousal beneficiaries and spouses electing to be treated as beneficiaries is the five-year rule. Under the five-year rule, the beneficiary must withdraw the entire interest from the IRA by December 31 of the year containing the fifth anniversary of the decedent’s death [IRC section 401(a)(9)(B)(ii); Treasury Regulations section 1.401(A-2)]. The beneficiary is generally free to withdraw any amount before the five-year date, or to wait until the fifth year to withdraw the entire interest [Treasury Regulations section 1.401(a)(9)-3(A-2)].
CPAs should note that the election to use the life expectancy rule or the five-year rule must be made on December 31 of the year that the beneficiary/spouse is required to take the first life expectancy payment or the five-year payment, whichever comes first [Treasury Regulations section 1.401(a)(9)-3(A-4)(c)]. Once made, this election is generally irrevocable and applies to all subsequent years. Furthermore, if no election is made, the default provision for designated beneficiaries is the life expectancy rule [Treasury Regulations section 1.401(a)(9)-3(A-4)(a)]. Nondesignated beneficiaries generally must use the five-year rule [IRC section 401(a)(9)(B)(iii)]. Note, however, that a plan provider is free to mandate the use of the five-year rule if no election is made, even for designated beneficiaries [Treasury Regulations section 1.401(a)(9)-3(A-4)(c)].
The rules regarding inherited IRAs can be complex, and often taxpayers must take several steps to ensure that their beneficiaries recieve the maximum finincal and tax benefits possible.
Recommendations for CPAs
The rules regarding inherited IRAs can be complex, and often taxpayers must take several steps to ensure that their beneficiaries receive the maximum financial and tax benefits possible. As baby boomers approach their sunset years, CPAs should familiarize themselves with the intricacies of the rules surrounding inherited IRAs. Knowing these rules will allow CPAs to advise their clients on the most tax-efficient method of transferring wealth, in view of their individual facts and circumstances.
CPAs should also familiarize themselves with the “Worksheet for Determining Required Minimum Distributions” and “Life Expectancy Tables,” which can be found in IRS Publication 590-B, Distributions from Individual Retirement Arrangements(IRAs). The tables cover decedents, surviving spouses, and beneficiaries.
In addition, CPAs should keep in mind that there might be specific rules that provide more flexibility. For instance, nonspousal beneficiaries cannot roll over amounts, but they may be able to transfer the funds via a trustee-to-trustee transfer to another IRA designated as an “inherited” IRA [Revenue Ruling 78-406]. Lastly, CPAs should advise clients to review the rules of their plans. For example, some plans may mandate that the beneficiary select the five-year method of distribution for the funds, even if the beneficiary qualifies for lifetime withdrawal under the IRC and Treasury regulations [section 1.401(a)(9)-3(A-4)(b)].