Dear Readers,
A couple of columns on IRAs ("IRA + VA = Bear Market Protection" and "Take Care if you Inherit an IRA ") raised a lot of questions. I've bundled them together and will answer a number of them.
Dear Gail,
You wrote that the withdrawal rate on an inherited IRA is based on the life expectancy of the beneficiary -- and not of the deceased IRA owner. This would make a HUGE difference for me. I inherited my father's IRA. I've been basing my withdrawals on his remaining life expectancy (had he lived) and not my own.
Since he was 26 when I was born, from what you say, I could really reduce my withdrawal rate. If I have withdrawn at the higher rate for several years and now switch to one based on my own life expectancy, will this alert an IRS and get me into trouble? Can this change even be made or is it too late? I have successfully grown the inheritance through the years and any help with reducing the taxation on smaller withdrawals would help me and my heirs.
Thank you,
hat
Dear "hat"-
First of all, I have to ask... What's with the "hat" thing? Do you have an aversion to capital letters? Is this a nickname for "Hatty"? Are you related to any felines, as in "The Cat in the ...?" Sorry, just curious. Since you claim to have a life expectancy, at least I know you are a bona fide person and not an object to be worn on the head.
OK, on to your answer.
You have correctly understood my column: when a non-spouse beneficiary inherits an IRA, she must either:
1. Start withdrawing a minimum amount each year based on her own life expectancy, beginning by 12/31 of the year after the IRA owner died, or,
2. If you miss this deadline, completely drain the IRA within 5 years after the year of death.
As you clearly comprehend (not bad for a "hat," I might add!), the longer the life expectancy associated with the IRA, the smaller the "minimum" amount that has to be withdrawn each year. Since taxes are due on withdrawal, this not only reduces the amount of income tax the beneficiary owes on the withdrawal, it also means more assets remain inside the IRA where they can continue to enjoy tax-sheltered growth.
I assume from your letter that you began withdrawals by the Dec. 31 deadline, so that's not an issue. But you have used your father's (shorter) life expectancy instead of your own to calculate the amount you are required to withdraw each year.
In the eyes of the IRS, all you have been doing is taking out more than the "minimum" each year -- which you are certainly allowed to do. The faster you withdraw the money, the faster those taxes get sent to Washington.
But it is perfectly fine for you to slow down your withdrawals and truly take just the minimum each year by switching to your own (longer) life expectancy.
I'm impressed that, despite withdrawing more than required, to you've managed to grow the value of your dad's IRA. As they say, "Hats off to you!" Or rather, "hat off to you!"
Gail
We know the beneficiary named by the decedent can disclaim an interest in an inherited IRA, resulting in the distribution going directly to the next beneficiary in line.
But here's our question: My wife Cindy is the sole beneficiary of an IRA left to her by her 76-year-old divorced mother, Gloria. No one was named contingent beneficiary of the IRA. Gloria left a solid will, leaving all of her estate assets to be split equally among her four children, including Cindy. For numerous reasons Cindy is contemplating disclaiming the IRA. Who would be the next beneficiary in line? She does not want it to go into the estate.
Thank you,
Tom
Dear Tom-
You are correct: Just because someone leaves you an asset, this doesn't mean you have to accept it. This includes financial assets such as IRAs. In legalese, refusing to accept such an asset is called a "disclaimer."
Think of it this way: if you accept an item left to you by someone who has died, you are claiming that asset. If you refuse it, you are disclaiming it.
A disclaimer is pretty straightforward: It must be completed within 9 months after the date of death and it must be in writing. You have to include very specific language, so you should probably consult a legal advisor as to the wording.
Once you disclaim the item, you lose all control over it. For instance, suppose your Uncle Fergy leaves you his bass boat. You live in a loft in Chicago and have an aversion to water. However, your brother, Leroy, is a fishing fanatic. Even ties his own lures. You want to disclaim the bass boat and instruct the executor of Uncle Fergy's estate to give it to your brother, instead. No dice.
The person who disclaims the asset has no power to appoint someone else to receive it in their place. Instead, it will pass to the person next-in-line that the decedent named in his will or, in the case of a retirement account, in the adoption agreement.
If, as in the case of Gloria's IRA, there is no contingent beneficiary, then in most cases the asset will pass to the decedent's estate. If there is a valid will, then the IRA will be distributed according to the terms spelled out in that document.
I say "in most cases" the IRA will pass to the estate if there is no contingent beneficiary because not all IRAs are created equal. Some IRA custodians have safeguards incorporated into their IRA adoption agreements.
For instance, the adoption agreement might provide that, if no contingent beneficiary has been specifically named, it is presumed that the IRA owner wanted his spouse to inherit it; if there is no living spouse, then the adoption agreement might specify that the beneficiary defaults to the IRA owner's children. Only after these options are exhausted would the IRA pass to the estate.
Your estate is the worst possible beneficiary for your IRA, or any other retirement assets for that matter. That's because an "estate" is not a living person, so it has no life expectancy. Without a life expectancy, the IRA withdrawals cannot be "stretched".
In other words, an IRA left to a non-living entity -- the Humane Society, your alma mater, your estate -- must be completely drained either:
1. Within 5 years, if the IRA owner had not started her "Required Minimum Distributions" (deadline is April 1, the year after she turned 70 1/2) or,
2. Over the decedent's remaining life expectancy, (had she lived), if her Required Distributions had begun (or if they had not begun, provide your IRA permits this method).
Either scenario means Gloria's IRA will be distributed sooner than it would be if your wife accepted it. This will accelerate the income tax bill owed by those who receive the withdrawals. More significantly, everyone loses the possibility of potentially decades of continued tax-favored growth.
If your wife disclaims Gloria's IRA, in all probability it will end up passing to her estate. Your only hope is that the IRA agreement itself contains language that might prevent this. Get your hands on a copy of the agreement and read it carefully. It's a long shot, but might be worth it.
Hope this helps,
Gail
Gail,
The information about Stretch IRAs in your previous article was interesting. However your examples had only one beneficiary. I have my three children as equal co-beneficiaries of my IRA. Can they stretch their share of the IRA throughout their lifetime if they desired?
Thanks.
Emily
Dear Emily,
Yes, they can. The key is that in your IRA adoption agreement you specified the percentage that goes to each beneficiary. Stating that your three children are to receive "equal shares" is the same as saying each child is entitled to 33 1/3 percent of your IRA.
Upon your death, your IRA should be equally divided into three separate "beneficiary" or "decedent" IRAs (the term varies, but the concept is the same) -- with a different child as the beneficiary on each. Once the IRA is divvied up, each child is free to do what he/she wants with his/her share.
For instance, one child might decide he needs the money for a down payment on a house and cash out his portion in a lump sum. Another child could opt to "stretch" the IRA and just take the minimum out each year based on her own life expectancy. The third might stretch out the IRA for awhile and then cash it out.
When your children are old enough to understand the benefit of stretching your inherited IRA as opposed to cashing it out, be sure to explain this concept to them. Let them know mom's preference and the reason for it.
Frankly, while stretching out an inherited IRA can make a lot of sense, there's no guarantee your kids will do this. And once you're dead there's not much you can do about it!
I know of only two ways to force a beneficiary to use a stretch:
1. Set up a trust, with all of the inherent legal fees, and complexities, or;
2. Invest your IRA in a variable annuity.
Many insurance companies which offer VAs will allow the IRA owner to stipulate that, upon their death, their contract is to be annuitized over the life expectancy of their beneficiary. They'll even allow you to specify that the beneficiary is to be paid once a year, semi-annually, monthly, etc.
Hope this helps!
Gail
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