Sunday, October 2, 2011

I just inherited an IRA. Now what?

A designated beneficiary of an IRA has a couple of choices to make regarding distributions from the account, but most of the provisions of the law are mandatory. As always, unless it is a Roth IRA, distributions from the account are taxed as ordinary income. Unless a spouse inherits the account, mandatory annual distributions must begin by December 31 of the year after the death of the IRA owner.

The words and phrases that we use are defined as follows:
  • The participant is the original owner of the IRA, the person whose earnings were contributed while working.
  • The designated beneficiary (DB) is a person who has been properly named on the account. The DB must be a natural person or, if properly designed, a trust.
  • The contingent beneficiary is a person who has been named as such. If the DB predeceases the participant, the person named as contingent beneficiary succeeds and has the rights of the DB as described below. Note that the contingent beneficiary has no interest in the account if the DB dies after the participant.
  • The life expectancy of a participant or beneficiary is calculated using formulas and tables that the IRS has devised for this purpose.
  • The required beginning date is the date by which the participant is required to begin taking distributions from the account. It is defined as April 1 of the year after the participant "reaches age 70½".
The "stretch" effect, the ability to delay mandatory distributions of taxable income and allow the principal to continue to grow tax-free, is available to the successor of a participant under age 70 only if he was properly named as a DB by the participant. (A 50-year-old DB of an IRA worth $100,000 is required to take a distribution of $3,021, for example. The required distribution to a 20-year-old DB would be less than $2,000.)

If the DB is the spouse of the deceased participant, he may elect to convert the account to his own name. If he does so, then his required beginning date and his life expectancy will apply. He will not have to take mandatory distributions until after he reaches age 70.

If the DB is a non-spouse, the rules are:

1. If the participant had not reached his required beginning date before his death, the custodian of the account must begin making annual distributions based on the life expectancy of the DB.
  • If there are two or more people named as DB, the life expectancy of the oldest must be used. Alternatively, the account may be divided into two or more separate accounts, and the separate life expectancy of each will govern his part.
  • Dividing the account is a way to keep the ability to stretch out distributions if a charity has been named as one beneficiary. There is a time limit for doing this.
2. If the participant had already reached the date on which he was required to begin taking distributions, then the distributions to a DB will also be based on that DB's life expectancy. (If the non-spouse DB was older than the participant, though, distributions will continue based on the participant's life expectancy.) If there is no DB, the distributions will continue on the same schedule that applied to the participant, using his life expectancy.

If the participant had not taken his required distribution for the year he died, it must be taken by December 31 of that year. It is taken by the beneficiary, not by the participant's estate.

The DB should always take steps to name his own beneficiary of the account and a contingent beneficiary. This person may not be a "designated beneficiary", as that term is used under the statute and regulations, but if not, he or should would continue the schedule of distributions that the DB had started.

If there was no DB on the account, such as a situation where the account is payable to the estate of the participant, the "stretch" is lost. A shortened payout period applies if the participant had not reached his required beginning date: the funds have to be distributed in full within five years of the participant's death to the person(s) entitled to them. If he had reached his required beginning date, however, the distributions may continue based on his life expectancy.

More: The Zucker Law Firm discusses the Five Options available to beneficiaries

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