Are you the current owner of an individual retirement arrangement (IRA) or, perhaps, a beneficiary of one? There are several different distribution options available to those who are beneficiaries of an IRA and these options differ depending on who the designated beneficiary is, whether it be a spouse or someone other than a spouse. These different options can make a big impact on the tax implications for the beneficiary.
When deciding what you want done with your individual retirement arrangements (IRAs), designating who you want as a beneficiary with the brokerage firm where the accounts are held is crucial to keeping the accounts from going through probate. Depending on who you designate as a beneficiary, the person who inherits your IRA may face very different tax consequences depending on whether or not they are your spouse.
Widows and widowers who inherit an IRA from their deceased spouse have an advantage over non-spouse beneficiaries: only spouses who are the sole beneficiary of an inherited IRA may opt to transfer the money into their own IRA and have the assets be treated exactly the same as any other assets in their IRA. This option allows for the assets from the inherited IRA to continue to grow tax-deferred. However, the spousal beneficiary will face the same restrictions on taking distributions from the inherited IRA funds as they would from any of their other IRA funds – namely, a 10% early withdrawal penalty if they are under 59 ½ years old. Even so, naming a spouse as the designated beneficiary of your IRA so that they can treat the IRA as their own is generally the most tax-efficient way to pass along your IRAs.
An additional three options are available for both spousal and non-spousal beneficiaries of an inherited IRA:
- 5 Year Method: If the deceased account holder was under 70 ½ years old at the time of their death, the beneficiaries may choose to transfer the assets into their own IRA accounts. They can leave the assets to grow tax-deferred in their own IRA accounts for up to five years. The beneficiaries can withdraw the assets at any time without facing the 10% early withdrawal penalty. However, by December 31st of the fifth year after the date of death all of the assets from the inherited IRA need to be fully distributed, with income tax paid on the distributions if they were made from a traditional IRA or the earnings of a Roth IRA that was less than five years old at the date of death.
- Life Expectancy Method: Under the life expectancy method, the beneficiaries each transfer their share of the IRA into an inherited IRA account. They will then take mandatory distributions from the IRA each year, beginning no later than December 31st of the year after the date of death.
The required minimum distributions will be based on the single life expectancy of the beneficiary. If multiple beneficiaries are named, the distributions will be based on the life expectancy of the oldest beneficiary on the account, potentially generating larger distributions and larger tax burdens and fewer opportunities for the assets to grow tax-deferred. This is why it is so important to create separate accounts for each beneficiary. Generally, the required minimum distributions for trusts, charities, and other entity beneficiaries are based on the remaining single life expectancy of the deceased, with some exceptions. The distributions will not be subject to the 10% early withdrawal penalty.
- Lump Sum Distribution: The beneficiaries can choose to take all of the money out of the inherited IRA at once. They will pay income tax on the distribution as if the assets were in a traditional IRA and on the earnings of a Roth IRA that was less than five years old at the date of death. The distribution will not be subject to the 10% early withdrawal penalty. This option should be carefully considered before it is undertaken since doing so may push the beneficiaries into a higher tax bracket.
Figuring out how to bequeath your IRAs or how to take distributions from your inherited IRA in the most tax-efficient manner can be a confusing process. If you have any questions about inherited IRAs or any other tax issue, please do not hesitate to contact your L&B professional at (858) 558-9200.