You can make a few very smart moves and significantly cut the taxes on inherited IRA distributions. The best way to show you how to do this is by way of example.
Let’s say that you and your two sisters are the named beneficiaries of your father’s IRA. Unfortunately, your father passes away. You now have three choices:
1. Start taking required minimum beneficiary IRA distributions by December 31st of the year after your father dies. This way, you’ll only have to take a relatively small amount out as an RMD and allow the balance to grow tax-deferred. Remember, every dollar you withdraw will be taxed at your normal income tax rates. The longer you defer that tax, the longer your money compounds for your own benefit.
2. Take all the money out of the account within five years of his death. (Bad idea. If you do this, you throw away the huge benefit of decades-long tax deferral.)
3. Pay a 50% penalty. (Super bad idea. The government has enough of your money. This is the worst inherited IRA mistake possible.)
As you can see, the first option is the best one by default. But you can make the “best” choice even better. Your goal should be to cut the required minimum distribution as much as possible and thereby cut the tax. You can do that by simply dividing up your deceased father’s IRA into one IRA for each beneficiary. Why?
If you do nothing, the amount of your RMD will be calculated using the oldest beneficiary’s age. That means even though your sister is 20 years older than you, you’ll have to take out the exact same amount that she does. That means you’ll take out more than you are required to. You’ll pay more tax than you have to and you’ll give up tax deferral faster than you otherwise would. Bad combo.
The good news is that since you are younger, you are eligible to take out significantly less (and thereby allow significantly more money to grow tax-deferred). So if you inherit money as a non-spouse IRA beneficiary and other people are also named beneficiaries, split up the IRA. This is especially powerful if the beneficiaries vary in age.
When must you split up the IRA?
In order to take advantage of this benefit, you have to set up the separate beneficiary IRA accounts before December 31st of the year after the IRA owner passes away.
How do you split up the accounts?
That’s easy. Just contact your IRA custodian and tell them what you want to do. They’ll likely need a copy of the owner’s death certificate and not much else. Once the accounts are established, have the custodian split up the money. Then make sure to satisfy your RMD for your own account. Simple as pie.
What if a non-individual is also named as beneficiary?
If the owner names you, your siblings AND a charity or an estate beneficiary, you have to be careful. If you do nothing, all the beneficiaries will have to empty the account within five years of the owner’s death. Fortunately, there is a way around this too.
The individual beneficiaries should ask the custodian to pay out all the money due the non-individual beneficiary by September 30th in the year following the death of the owner. Then, the non-individual won’t be considered a beneficiary anymore, and the living beneficiaries can set up their separate accounts and split up the IRA. Just make sure to do this before December 31st of the year following the death of the IRA owner.
If you do this, you can take your RMDs over your life expectancy. Each beneficiary can stretch out that money for the longest period possible and enjoy the best tax deferral possible.
Winship says
March 12, 2012 at 2:41 PMContingent beneficiary named as “estate.” Rather than the specific names of two adult children. Discuss the consequences, please and thank you.
Neal Frankle says
March 13, 2012 at 1:50 AMA great subject for an entire post. I’ll work it up. Stay tuned Winship