The worst part of being a financial advisor is seeing a client pass away. This year has been especially tough for me, as two long-time clients of mine have passed away.
It is difficult to talk with beneficiaries, some of whom I am meeting for the first time, after they suffered such a terrible loss. I can do my small part by making sure that my client’s beneficiary designations are in order. And when the time comes, I can help the beneficiaries through their maze of options. For example, when someone inherits an IRA, the particular relationship between the individual that passed away and the beneficiary dictates the available choices. When the spouse is the sole beneficiary, that person can either remain a beneficiary or become the owner of the IRA.
To avoid paying the 10% penalty on withdrawals, spouses under the age of 59½ who need access to the IRA should consider remaining a beneficiary, as any withdrawals made by beneficiaries are exempt from the penalty. If it makes sense to become the owner in the future, they can always do so at a later date.
Spouses over 70½ should also consider remaining beneficiaries. When they reach that age, the government requires the IRA’s owner to begin taking distributions from it. For example, if a spouse passes away at age 65 and the surviving spouse is over 70½, then, by remaining as a beneficiary, the surviving spouse has a six-year window before they must take a distribution.
Spouses are the only beneficiaries who can become owners. They can move the inherited IRA into their own IRA, 401(k), or 403(b). Just remember: if a spouse becomes the owner, then that person’s age becomes the yardstick that determines whether a withdrawal is subject to the 10% penalty. The age also determines when distributions are required to take effect. This could benefit a younger spouse who wants to put off distributions for as long as possible.
One big caveat: the option for a spouse to become the owner is allowed only if the spouse was the sole beneficiary.
Read more: Saving for Retirement at Work
The least likely choice for spouses is to disinherit the IRA, thus becoming neither owner nor beneficiary. This might happen in a wealthy family in which the spouse does not need additional taxable income but instead wishes to change places with the contingent beneficiary and provide withdrawals over a longer period to the kids or grandkids.
When anyone other than a spouse inherits an IRA, that person’s only choice is to be a beneficiary. In that case, recipients must: (1) make a trustee-to-trustee transfer of the inherited IRA, and (2) make sure to title the new IRA in the deceased owner’s name for the benefit of themselves as beneficiary. This provides beneficiaries the option of stretching the withdrawals out over their lifetimes and hopefully lessening the tax burden.
The beneficiary pays no taxes when this is done, but must pay taxes when distributions begin. However, there is no 10% penalty on any distributions. Moreover, when and how beneficiaries receive the first distributions is critical. Beneficiaries must begin taking distributions within the year following the death of the IRA owner. The amount they must take gets figured on their life expectancy in that year.
For example, if beneficiaries are age 50, their life expectancy is 34.2 years. To figure out the amount they need to withdraw, they divide 34.2 into the value their share of the IRA had been at the start of the year. The following year, they subtract one year, thus dividing the new balance by 33.2.
If the beneficiary fails to take this amount out, the only option is to withdraw the entire account by December 31 of the fifth year following the death of the beneficiary’s spouse.
This ability to stretch out withdrawals over a lifetime is available only if all of the IRA beneficiaries are natural persons. If one beneficiary is the deceased person’s estate, a college or university, or another institution, then the individuals can use only the five-year option.
Also, if more than one natural person are beneficiaries, then all recipients use the age of the oldest beneficiary to determine their yearly withdrawal. However, not all recipients have to stretch. One recipient can take out a percentage in the first five years, while another still can stretch it out over a lifetime.
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only, and should not be construed or acted upon as individualized investment advice.