Todd M. Siebert: Do not let your heirs fumble your IRA

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.

Paying taxes. Many beneficiaries don’t realize they are taxed on distributions from an inherited traditional IRA the same way the original owner would have been. Distributions of pre-tax contributions and accumulated income and gains are included in gross income and taxed as ordinary income. Your heirs really are inheriting only the after-tax value. Too many beneficiaries spend the entire IRA balance quickly only to learn later that income taxes are due.
Retitling the IRA. An inherited IRA must be retitled if the beneficiary (or beneficiaries) wants to have a Stretch IRA and continue to benefit from tax deferral. If it isn’t retitled or is retitled improperly, the beneficiary must empty the IRA and pay any taxes in no more than five years. It should be a simple process, but the IRS requires precise language or the Stretch IRA is lost.

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.

Preparing for the process. Beneficiaries need to know that the retitling process isn’t automatic. The IRA custodian has to be sure that the original IRA owner passed away and that the person requesting a change is the beneficiary (or one of the beneficiaries) entitled to inherit 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 forms of the custodian. In other words, the process will take time, and heirs need to realize that.
Moving the A beneficiary often wants to transfer an inherited IRA to a financial institution where the beneficiary has other accounts. But the beneficiary has to understand that certain requirements have to be met for the transfer to qualify as a tax-free rollover and not a taxable 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.

Special rules for surviving spouses. A surviving spouse who is the sole primary beneficiary of an IRA is excused from many of these rules. The surviving spouse can, after establishing his or her bona fides with the custodian, have the inherited IRA rolled over to his or her own IRA, either a new one or an already existing one. That will be a tax-free transaction, not a distribution.

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.

Limits of the Stretch IRA. Required minimum distributions (RMDs) must begin from an inherited IRA by December 31 or the year following the owner’s death. The RMD schedule might be based on the deceased owner’s age at death or the oldest beneficiary’s age, depending on the circumstances.

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.

Do you want to learn more about this and the other financial issues of retirement and retirement planning? Give us just 90 days, and we’ll help you build a richer, worry-free retirement… or your money back. Click here to check out the monthly advisory, Bob Carlson’s Retirement Watch, plus access to our feature-rich, members-only website. On the members’ website you’ll find regular updates, early access to each monthly advisory, an Archive to enhance your retirement research, Bob’s Journal and more.

— Bob Carlson

Robert C. Carlson is the author of the book “The New Rules of Retirement” and editor the popular retirement newsletter, Retirement Watch.

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