With the exception of financial experts, deciphering the rules of individual retirement accounts can often leave a person confused and frustrated. While the gist of most IRAs is relatively easy to comprehend, once a person begins investigating the rules, requirements and exclusions, things tend to get a bit tricky. This becomes even more apparent when you find yourself named as a beneficiary of an IRA from a friend or family member who has passed.

Inherited IRAs constitute some of the largest assets left in an estate. For this reason any heirs who find themselves in a position of deciding what to do with an inherited IRA should think carefully about all the options before making their final decision. Since this decision can have a huge impact on your own personal finances (in both positive and negative ways) most beneficiaries will benefit by consulting with a tax professional or financial advisor experienced in this area.

The following information is provided to help you understand what options are available to you regarding inherited IRA rules. Distribution of assets for some IRAs must begin at age 70 1/2 (April 1 of the year following this birthday), therefore some of the options are based on whether the owner of the IRA died before or after that cut off date.

Five year rule of Inheriting an IRA

photo credit: Mykl Roventine

When the owner of the IRA does not specify a beneficiary or simply names the estate as the beneficiary, the rules for withdrawal or distribution of assets state the entire amount of the IRA must be distributed by December 31st of the fifth year following the death of the owner. This five year rule applies if the owner of the IRA passed away before mandatory distributions began. If the owner of the IRA had already passed the mandatory distribution age, the distribution of the IRA must follow the terms elected by the owner.

Non-spousal beneficiaries

For non-spouse beneficiaries who inherit an IRA after the minimum distribution date has passed, options are fairly limited. In most cases you would have to follow the same distribution schedule set forth by the owner of the IRA, this includes collective life expectancies or recalculating life expectancies. If the owner of the IRA passes away prior to the mandatory distribution date, you may elect to have the entire balance distributed within five years or over a period not to exceed your life expectancy.  This is what is referred to as a stretch IRA.

Inheriting an IRA from a Spouse

If the owner of the IRA was your spouse, you have the same options available to you as that of a non-spouse beneficiary. In addition, you may opt to treat the inherited IRA as your own which would eliminate the minimum distribution rules that normally apply after the owner of the IRA has passed. If this option is taken, the surviving spouse then becomes the owner of the IRA and the benefits and rules apply to the surviving spouse not the decedent.

As you can see there are many rules and restrictions that apply to the distribution of IRAs after the owner has passed. As the beneficiary of an inherited IRA, it is imperative that you research and understand all of the rules and restrictions to avoid making decisions that will cost you money down the road, either in the form of lost earnings or paying too much to the government. By handling the inherited IRA in the best possible manner, you have the opportunity to benefit from the inheritance as the owner surely intended when they named you as a beneficiary.

This is a guest post from Junior Boomer who runs the blog Consumer Boomer, aimed at the Baby Boomer generation. Consumer Boomer is not endorsed or affiliated with LPL Financial.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
photo credit: VoisineN

photo credit: elora.daphne

IRA’s (Individual Retirement Accounts) are a vital tool in retirement planning.   Younger investors may prefer the Roth IRA, while baby boomers may choose the traditional IRA.   When you retire, you may want to convert all your retirement assets into a rollover IRA.   So many choices and even more options can leave somebody overwhelmed on what the right IRA to choose when planning for retirement.   If you have an IRA, be sure to avoid these 12 mistakes:

1. Not taking advantage of the stretch distribution option or not establishing it properly.

The “stretch IRA” is a way for each IRA beneficiary to maximize payouts over his or her entire life expectancy. Properly designating beneficiaries and informing them of the IRA owner’s “stretch” intentions are key to making this strategy work.

2. Not naming or updating IRA beneficiaries.

Not listing primary and contingent beneficiaries may result in the distribution of the IRA assets to the IRA owner’s estate, resulting in accelerated distribution and taxation. Not keeping beneficiary designations current and coordinating them with other estate planning documents can also lead to conflicts and unintended results.

3. Making inappropriate spousal rollovers.

Most IRAs list the owner’s spouse as the primary beneficiary. One of the most popular strategies for a spousal beneficiary is simply to roll the inherited IRA into his or her own IRA. But in some cases it can be more tax efficient for a surviving spouse to keep the IRA as an inherited beneficiary IRA or disclaim the assets, thereby allowing them to pass to the contingent beneficiary.

4. Not taking advantage of “IRD” if you are a beneficiary.

Upon the death of the IRA owner, his or her IRA is included in the estate, creating an estate tax liability (if applicable) as well as an income tax liability for beneficiaries. Many IRA beneficiaries do not realize that IRAs are considered “Income in Respect of a Decedent” (IRD), according to Section 691(c) of the IRS Code. The IRD designation allows beneficiaries to take a federal income tax deduction for any estate taxes paid on the IRA’s assets, thus limiting double taxation of the IRA assets.

5. Rolling low-cost-basis company stock into an IRA.

Distributions from a qualified plan such as a 401(k) are generally taxed as ordinary income; federal income tax rates range from 10% to 35% (as of 2009). If company stock is rolled into an IRA, future distributions are taxed as ordinary income. If, instead, the company stock is taken as a lump-sum distribution from the qualified plan, only the cost basis of the stock is taxed as ordinary income. This is called Net Unrealized Appreciation. (Note: The distribution must be taken as stock, not cash.) Unrealized capital appreciation (the difference between the cost basis and current fair market value) is not taxed until the stock is sold, upon which it would be taxed as long-term capital gains, which are taxed at a lower rate than ordinary income (at 2009 tax rates). Be sure to talk with your tax advisor.

6. Not taking advantage of a Roth IRA.

A Roth IRA is a potentially valuable retirement resource. Not only are qualified withdrawals tax free, but Roth IRA distributions do not impact the taxability of Social Security, and Roth accounts pass to beneficiaries tax free as long as the account passes the five year rule for qualified distributions. There are income limits that affect eligibility for a Roth IRA, so be sure to talk this option over with your financial advisor.

7. Not taking advantage of increased contribution limits.

The contribution limits for 2009 are $5,000.  IRA owners age 50 or older can make an additional $1,000 “catch-up” contribution in 2009. Roth IRA limits and traditional IRA limits are the same.

8. Assuming that a nonworking spouse cannot contribute.

The truth is that separate “spousal” IRAs may be established for spouses with little or no income up to the same limits as the working spouse.

9. Missing important dates.

Estate taxes, if applicable, are due nine months after the IRA owner’s death. The same deadline applies to beneficiaries who wish to disclaim IRA assets. By September 30 of the year following the year of the owner’s death, the beneficiary whose life expectancy will control the payout period must be identified. Generally, IRA beneficiaries who want to receive distributions over a life expectancy must begin taking required distributions by December 31 of that same year.

10. Taking the wrong required minimum distribution (RMD).

IRA owners in their seventies are required to take the RMD out of their accounts each year, based on the value of all their non-Roth IRAs. Those who do not take enough out each year may be subject to a federal income tax penalty of 50% of the amount that should have been taken as an RMD but was not. Consolidating retirement assets may make it easier to manage these distributions. Current law allows a one-time suspension of the requirement to take an RMD for 2009. RMDs must resume in 2010.

11. Placing the title of an IRA in trust.

Making a trust the actual owner of an IRA causes immediate taxation — including the 10% penalty tax if the IRA holder is under age 591⁄2.

12. Paying unnecessary penalties on early (pre-age 591⁄2) IRA distributions.

As long as withdrawals are made in accordance with the requirements of IRS Code Section 72(t), there is no need to pay penalties on distributions from IRAs before the owner is age 591⁄2. Section 72(t) allows for three calculation methods to determine substantially equal periodic payments based on the owner’s life expectancy. Payments must continue for 5 years or until age 591⁄2, whichever is the longer period of time.

photo by Charles NJC

*Restrictions, penalties and taxes may apply.  Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

Stretch Out Your IRA

If you don’t expect to deplete the assets in an IRA during retirement, then it’s a good idea to determine the most efficient way of transferring the account balance to your heirs in a manner that preserves the account’s tax-deferred growth potential for as long as possible. For many Americans, transferring wealth with a multi-generational stretch IRA can be an ideal solution. By naming a younger individual as the beneficiary, he or she will be able to stretch the life of the IRA by making (smaller) required withdrawals based on his or her (longer) life expectancy. With a “stretch IRA” strategy, more money can then remain in the IRA with the potential for continued tax-deferred growth. For those who do not currently have any IRA beneficiaries, the stretch technique could provide significantly greater long-term benefits than simply allowing the account balance to be paid out to your estate as a taxable lump-sum distribution.

Stretch IRAs were made significantly more convenient when the IRS revised the rules governing required minimum distributions (RMDs) from IRAs. Please keep in mind that the required minimum distributions have been suspended for 2009, but will resume in 2010. The three key rule changes affecting stretch IRA allow you to:

1. Name beneficiaries after RMDs have begun
2. Change beneficiary designations after the account owner’s death
3. Receive RMDs as a beneficiary that are calculated based on your own life expectancy

Whether you’ve amassed assets in an individual retirement account (IRA) by making regular contributions through the years or by “rolling over” a lump-sum distribution from a workplace retirement plan, you may want to consider whether it will be necessary to use all of that money to support yourself during retirement. If the answer is “no” (or even “maybe not”) then you’ll need to determine the most efficient way of leaving the account balance to your heirs while simultaneously safeguarding your accumulated wealth for as long as possible.

Stretch It Out

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For many Americans, transferring wealth with a multigenerational “stretch” IRA is an ideal solution. A stretch IRA is a strategy for a traditional IRA that passes from the account owner to a younger beneficiary at the time of the account owner’s death. Since the younger beneficiary has a longer life expectancy than the original IRA owner, he or she will be able to “stretch” the life of the IRA by receiving smaller required minimum distributions (RMDs) each year over his or her life span. More money can then remain in the IRA with the potential for continued tax-deferred growth.

Creating a stretch IRA has no effect on the account owner’s minimum distribution requirements, which continue to be based on his or her life expectancy. Once the account owner dies, however, beneficiaries begin taking RMDs based on their own life expectancies. Whereas the owner of a stretch IRA must begin receiving RMDs after reaching age 70 1/2, beneficiaries of a stretch IRA begin receiving RMDs after the account owner’s death. In either scenario, distributions are taxable to the payee at then-current income tax rates.

It’s worth noting that beneficiaries also have the right to receive the full value of their inherited IRA assets by the end of the fifth year following the year of the account owner’s death. However, by opting to take only the required minimum amount instead, a beneficiary can theoretically stretch the IRA and tax-deferred growth throughout his or her lifetime.

Added Perspectives

Your enhanced ability to stretch IRA assets is a direct result of an IRS decision to simplify the rules regarding RMDs from IRAs. The new rules allow beneficiaries to be named after the account owner’s RMDs have begun, and beneficiary designations can be changed after the account owner’s death (although no new beneficiaries may be named at that point). Also, the amount of a beneficiary’s RMD is based on his or her own life expectancy, even if the original account owner’s RMDs had already begun.
Consider the Implications

• The ability to name new beneficiaries after RMDs have begun means that you can include a child in your stretch IRA strategy regardless of when the child was born.
• The ability to change beneficiary designations after the account owner’s death means that one beneficiary may choose to disclaim his or her own beneficiary status so that more assets pass to another beneficiary. For example, if an account owner names his son as the primary beneficiary and his grandson as the secondary beneficiary, the son could remove himself as a beneficiary and allow the entire IRA to pass to the grandson. RMDs would then be based on the grandson’s life expectancy, not on the son’s life expectancy, as would have been the case if the son remained a beneficiary. (When there is more than one beneficiary, RMDs are calculated using the life expectancy of the oldest beneficiary.)
• The ability of beneficiaries to base RMDs on their own life expectancy means that the money you accumulate in your IRA and leave to heirs has the potential to last longer and produce more wealth for younger generations. (See example.)

Keep in mind that this information is presented for educational purposes only and does not represent tax or financial advice. While it is true that recent regulatory changes have indeed made it much easier to incorporate a stretch IRA into your multi-generational financial planning initiatives, it’s always a good idea to speak with a tax professional before implementing any new tax strategy.

Get a Good, Long Stretch

Stretch IRA in Action

Assume that you leave a $100,000 IRA to a five-year-old beneficiary who has an estimated life expectancy of 77.7 years, according to current IRS life expectancy tables. If the account earned an 8% average annual rate of return, its value could grow to $1.67 million by his or her 55th birthday. That amount is on top of the nearly $790,000 in taxable RMDs that would have been withdrawn from the account during the 50-year time period.*

* For illustrative purposes only. Not indicative of any particular investment.