This week, Gail discusses the important decisions that IRA beneficiaries have to make and the deadlines they need to meet.

Dear Gail,

When the owner of an IRA dies, are the disbursements to the heirs automatically sent from the beneficiary IRA? Would it be beneficial to put these disbursements into a traditional IRA to avoid the tax liabilities?

Thanks,
Pat

Dear Pat,
The rules governing inherited IRAs are complex. They vary based upon who inherited the IRA and the age of the deceased IRA owner.

As you know, when an IRA owner dies, the IRA passes to the individual(s) or entity named as beneficiary. But be careful: if the IRA owner was over age 70½ and had not yet withdrawn his Required Minimum Distribution (RMD) for the year of his death, this amount must be withdrawn before any part of the IRA is distributed to the beneficiaries. What happens after that depends upon who inherits the IRA.

If the beneficiary is the spouse (and there are no other beneficiaries), the person has several choices:

1. A spouse may "roll over" the IRA assets into an IRA in his or her own name. To see how this works, let's look at an example: If a wife takes this option when her husband dies, his name is removed from the account and from a tax and legal standpoint, the IRA is treated as if it had always belonged to the wife. This means she is free to make contributions to it (provided she has earned income and is not herself over 70½). And, even if the husband had been taking Required Minimum Distributions, if the surviving spouse is under age 70½, these can stop until she reaches that age — because now it is "her" IRA. However, it also means that in the case of a traditional IRA, if the surviving spouse is under age 59½, withdrawals are subject to ordinary income tax and the 10 percent "early withdrawal" penalty.

2. Without taking any formal action, the spouse beneficiary can simply treat the IRA as if it is her own — making contributions, taking withdrawals according to the regulations, and so forth.

3. Leave the deceased spouse's name on the IRA. This is called either a "decedent" or "beneficiary" IRA. This type of IRA requires that the beneficiary take minimum distributions each year. But a spouse beneficiary has much more flexibility than anyone else.

Depending upon the age of the original IRA owner, the surviving spouse can either start mandatory withdrawals in the year after the IRA owner died, or possibly postpone them until her husband would have had to start, that is, the year when he would have reached age 70½. This gives the IRA investments the potential to continue to grow on a tax-deferred basis.

Once the required distributions begin, they might be based upon the wife's life expectancy or, in some cases, on the life expectancy the husband would have had (if he had lived). The latter would be an advantage if the deceased spouse were the younger of the two; a longer life expectancy would result in smaller withdrawal amounts.

The main advantage to a "beneficiary" IRA is that the surviving spouse is not viewed as the IRA owner — the deceased spouse is. Since "death of the IRA owner" is one of the exceptions to the 10 percent penalty on early withdrawals, the husband could take money out of the inherited IRA in any amount and as frequently as he wants, even if he is under age 59½ without incurring a penalty. (Income tax, however, would still apply in the case of a traditional IRA.) So if a young spouse needs money to, say, support himself and the children, he is often better off not rolling over his wife's IRA.

If an IRA is left to someone who is not the spouse of the IRA owner, the options for the beneficiary are much less flexible. For starters, rolling over the IRA or treating it as your own is not an option; these are reserved for spouse beneficiaries only.

Thus, a non-spouse who inherits an IRA must leave the deceased owner's name on it. In addition, the person has to start Required Minimum Distributions (RMDs) by the end of the following year, and these must be based on the life expectancy of the beneficiary. If this deadline is missed, in most cases the entire inherited IRA has to be withdrawn by the fifth year after the IRA owner's death. However, because "death" provides an exception, there is never an early withdrawal penalty on distributions to a non-spouse beneficiary. Such a beneficiary can choose to withdraw the entire amount in the account instead of taking RMDs, but the withdrawals would, of course, be subject to ordinary income tax.

And there's one more wrinkle to consider: Special rules apply when there is a beneficiary on an IRA. For example, if a spouse is only one of two or more beneficiaries, the spouse loses the ability to treat the IRA as his or her own. Also, in that case, all beneficiaries must use the life expectancy of the oldest beneficiary — that is, the shortest life expectancy — to calculate their RMDs. And RMDs can be affected in other ways, too.

Beneficiaries do have an opportunity to avoid some of these consequences, however. The IRS doesn't treat a person as a beneficiary unless he or she still has an interest in the IRA on Sept. 30 of the year following the IRA owner's death. Beneficiaries who disclaim or withdraw their interests in the account before that date won't be treated as beneficiaries for RMD purposes. So, for example, the shorter life expectancy of an older beneficiary won't affect the RMDs of any remaining beneficiaries.

So, Pat, the answer to your first question is "No." The custodian for the deceased IRA owner does not automatically start distributing money to the beneficiaries. The beneficiary must notify the custodian that the IRA owner has died, how you want the IRA titled (if you're the spouse), and how you want to receive your portion of the IRA. And you must do this by Dec. 31 of the year following the year of death.

You cannot roll Required Distributions from any type of IRA into another IRA account to avoid taxes. I strongly advise IRA beneficiaries to seek professional guidance because mistakes can be costly.

Finally, a word to the living: Please do yourself — and your loved ones — a favor and make sure you have not named your "estate" as your IRA beneficiary. This greatly hinders the options for your heirs (including your spouse), who might have to drain your IRA — and pay any taxes due— as early as five years after your death.

Hope this helps,
Gail

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.