We have seen many cases where the IRA is held in the form of an annuity product, with the insurance company as the custodian. I have read many contracts that impose costs or other expenses to split the account into Inherited IRAs for multiple beneficiaries. Please review your contract carefully to make sure there is no penalty before you make this election.
In the event you find out that there is a potential penalty, at least there is usually a solution:
- Retitle the account as an Inherited IRA with multiple beneficiaries, but keep it as only one IRA.
- Open up a self-directed IRA at a brokerage firm with the same title.
- Transfer the Inherited IRA from the insurance company in kind via a trustee-to-trustee transfer over to the new self-directed Inherited IRA account.
- Liquidate the annuity product that is held by the self-directed Inherited IRA account (there should be no penalty or income taxes because the annuitant passed away and it is being paid out all at once and into another IRA).
- Once the proceeds come into this new self-directed Inherited IRA, then split it into the various Inherited IRAs for each of the beneficiaries.
Sounds like a lot of work? It is, and that is the reason why you need an advisor you can trust to guide you through the process and you will most likely want to review all of your IRAs at this time in order to avoid having all these problems in the future.
Many advisors think that the IRA custodian will act promptly when dealing with these matters. However, many of these custodians are not familiar with all of these new rules and tax laws and will consider them an “exception.” They will often run these “special cases” through their legal department and it often takes a lot longer than you might think in order to finalize all of the paperwork. It often takes three months or longer for the IRA custodian to transfer the accounts and get everything retitled properly. This is especially true if you have multiple IRA accounts. Therefore, it is wise to make the decisions and final changes regarding the splitting of the IRA as soon as possible after the person passes away in order to give the IRA custodian enough time to process all this paperwork.
While the following point is much less likely to occur due to the portability of exemption amounts between spouses it is still important to know the possibilty exists. It is also important to know just how easy this is to avoid by speaking with your advisor about your situation.
Let us assume that the beneficiary of the IRA was a revocable living trust (RLT) and that this trust states that upon the death of the first spouse, a new trust should be established and funded up to the current exemption equivalent. I have seen many cases where the attorney has “carved out” this exemption amount from the IRA in order to fund this exemption trust, and then suggested rolling over the difference into the surviving spouse’s IRA. Although this can be done, it has to be done properly!
I have seen countless examples where the exemption was in fact carved out and paid out directly into the exemption trust! One hundred percent of this money was subject to income taxation in one year, and if that isn’t bad enough, it was all taxed at the trust income tax rate brackets, which are usually much higher than individual income tax rates!
What should be done is to establish an Inherited IRA for the benefit of the exemption trust. Please remember that many attorneys and accountants have not heard of an Inherited IRA and believe that the exemption trust beneficiary would have to receive the money in order to have it funded. Please make sure that your financial advisor is aware of these complicated rules.
Again, this is an easy mistake to avoid based on new portabilty laws, but a situation involving funding of trusts for minors can come up. Remember that when people set up trusts for minors it is important the trust contains both the proper language to qualify for the stretch IRA and that the financial advisor properly titles the inherited IRA for the benefit of the trust established for the minor.
Information provided by MD Producer
There are a number of rules that must be met in order to properly establish an Inherited IRA:
- Notification must be made to the custodian in writing.
- The first minimum distribution must be taken no later than December 31st of the year following the year the person passes away. Note: if the decedent was receiving lifetime RMDs, the beneficiaries must ensure the RMD has been taken for the year of death.
- The IRA must be retitled properly showing the following information (something that Jim has covered on the radio show more than once, due to the number of times mistakes are made on this key point):
- The decedent’s name, with “deceased” or “decedent” after the name.
- It must show that it is still an IRA.
- Retitling must be done by December 31st after the year of death.
If these requirements are not met, then most beneficiaries will be faced with the following consequences:
- If the orginal account owner was RMD age or older, the IRA must be distributed over the owner’s remaining life expectancy, based on the single life table.
- If the orginal owner was under RMD age, the entire IRA account must be distributed no later than December 31st of the fifth year after the person passed away.
- If the account title is not worded properly the entire account could also be subject to immediate taxation all in one year!
Make sure you discuss all the vaious laws and titling issues with your advisor when establishing an inherited IRA.
Information adapted from MD Producer material
This is one of the most common mistakes for the following reasons:
- The client is not aware of the retirement distribution rules and merely asks for a total distribution of the IRA.
- The client asks the custodian/advisor what to do and is merely asked to sign a form so a check can be sent to them.
- The client’s CPA and/or lawyers are not familiar with this area of the tax law.
- The beneficiary is made aware of these new rules by the advisor and the beneficiary still says, “I need the money now. Give me the check!”
The last one is an example that I also encounter frequently. For example, a young man might come to me who is the beneficiary of his deceased father’s IRA. The IRA is worth $1 million. I look at the life expectancy table and explain to the son that if he makes the proper election, he will only be required to take out about $30,000 from the IRA and he could leave the other $970,000 tax deferred (I’ve also reviewed the entire estate and allocated for estate taxes).
In many cases, the child will respond, “Thank you for all that wonderful information. However, I would just as soon spend the money now! Close out my dad’s IRA and transfer all the money into my bank account.”
Unfortunately, this often happens in the real world and is a perfect example of improper planning! One of the key issues that an advisor should discuss with his client before he or she passes away is the possibility of establishing an Inherited IRA Trust, also known as an IRA Legacy Trust, Stretch IRA Trust, etc. This document specifically states what steps and elections the beneficiaries must take after the client passes away.
Ask your advisor about establishing an Inherited IRA Trust, which names a separate trustee to make decisions on behalf of the beneficiary. While it is not a perfect solution in every scenario, there are a lot of benefits in the right set of circumstances.
Not all custodians allow for this type of planning, and of course, not all situations warrant this type of planning. However, knowing your options can only help you when it is time to talk to your advisor.
Adapted from MD Producer materials
As I mentioned earlier, only a spouse may roll over an IRA into his or her name. This can happen in a variety of circumstances:
- The spouse is the primary beneficiary.
- The spouse is the contingent beneficiary and the primary beneficiaries disclaim their part.
- The beneficiary of the IRA is a trust/estate, and the spouse is the sole beneficiary of the trust/estate and all other conditions are met.
However, I have seen many cases where the beneficiary other than the spouse, such as the son or daughter, has taken the money and rolled it over into his or her own IRA! This is not allowed! Please remember that not only will the non-spouse beneficiary have to pay income taxes on this distribution all at once, but there is also a penalty for rolling over too much!
As mentioned above, the proper course of action would be for the non-spouse beneficiary to establish an Inherited IRA and at least allow the tax to be deferred over a long period of time, rather than paying the tax all at once.
As discussed earlier, non-spouse beneficiaries are allowed to directly transfer (i.e., a direct rollover) an inherited qualified plan to an inherited IRA as long as such a transfer is allowed under the plan document. It is important for your advisor to review your plan document to determine if such a rollover is allowed.
When such a transfer is made, the payout period that the beneficiary must follow under the IRA will depend on a number of factors.
If you are a non-spousal beneficiary of a qualified plan, it is highly recommended that you consult with an advisor who is familiar with the rules before you make a rollover to an Inherited IRA.
Adapted from MD Producer Materials
This is not usually a good idea until the entire finances of the deceased and the beneficiaries are reviewed in detail. I always recommend contacting the client’s CPA and estate attorney in order to determine whether or not there are going to be any estate tax issues. For example, it is possible that the surviving spouse would actually want to disclaim some or all of the IRA in order to reduce any unnecessary estate taxes.
In addition to this, if you roll over your spouse’s money into your name and you are under age 59 ½, you may have to pay a penalty if you need to take a distribution before you turn 59 ½. This is called the “Spousal Rollover Trap.”
One of the options you could take in these circumstances is to utilize section 72(t) of the Internal Revenue code and take out the money before age 59 ½ without paying a penalty by using “substantially equal payments.” However, if you are many years away from this date and if you leave money in the decedent’s IRA, then you can take out money from the decedent’s IRA without any restrictions at all!
As you can see, a surviving spouse must be careful to investigate all options before rolling over the decedent’s IRA into their own name.
Adapted from MD Producer Materials
You should try to limit the number of custodians because each IRA custodian is different and in order for you to remain current on the new rules and regulations, you must remember that each of the IRA custodians may or may not be current on all the tax laws. The more custodians that you have, the more work you will have to do in order to determine whether or not they are up-to-date.
Imagine if you have 10 IRA custodians, you would have to review 10 different custodial accounts and keep current on each of these changes as the IRA custodians make them!
Many IRA custodians may not allow you to implement your desired plan. If they are not flexible, then it is time to switch. Many beneficiaries are not aware that they do not necessarily have to put up with the prior owner’s custodian. The IRA can usually be transferred from one custodian to another IRA custodian without any tax consequences.
Adapted from MD Producer
This is a major issue, since many new tax laws may come into effect and, as mentioned earlier, the IRA custodian may not be familiar with or have even implemented these new rules.
With the ever-changing nature of the tax laws, it is vital that you meet with an experienced financial advisor so you know what is and what is not allowed and the proper way to handle your retirement plan distributions.
Adapted from MD Producer
Unfortunately, many beneficiaries do not seek a qualified tax or financial advisor and make retirement account decisions on their own or through the use of an unqualified individual or company.
There are a number of different rules that must be followed in order to prevent the IRS from being a primary beneficiary of your retirement account.
Your financial advisor should be competent in all of the different areas of financial planning, especially estate planning, income tax planning and retirement distributions. Please also remember that they should determine whether or not there is any estate tax due on the IRA account. Unfortunately, many people confuse “probate” with estate taxes. Retirement distributions will usually avoid probate, but are always subject to estate taxes. Therefore, please make sure that your advisor reviews this issue as well.
Many advisors may have heard of the Inherited IRA; however, many financial advisors have never established one before! Please ask your advisor/custodian how many Inherited IRAs they have established in the past because if this is the first time they have established one, we all know what happens the first time we do anything! It is called the learning curve. Many of the mistakes that I see are because the financial advisor is not familiar with all of the details and, unfortunately, the client is the “guinea pig.”
Remember the old expression, “We have theory, and then we have the real world.” Please make sure that your advisor understands the “real world.”
Be careful in choosing a custodian. It is often very difficult for custodians to keep up on all the new tax law changes and apply these to their custodial accounts because this is not usually a major priority since the profits on IRA account fees for many custodians is minimal or non-existent.
Your tax or financial advisor should also review your total financial picture before any decision is made because this inheritance can affect your current financial affairs. The financial advisor should review the impact of this inheritance in the following areas:
- Income taxes.
- Estate plan. You might not have had a large estate and now you do! You might need to have your will or trust updated due to this inheritance.
- Estate taxes.
- Investments. Your risk tolerance level could be significantly different from that of the individual who just passed away. Please check each of your investments to determine whether or not they are still appropriate. In most cases you will be able to reposition these assets within the IRA without any income tax consequence.
- Cash flow needs. It is very possible that you do not need the entire IRA balance all at once.
Talking through these points with your advisor will help you avoid some of the most common mistakes of inherited IRAs.
Material Adapted from MD Producer