What are my options if I inherit an IRA or benefit from an employer-sponsored plan?

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1 Ebert Associates What are my options if I inherit an IRA or benefit from an employer-sponsored plan? Answer: If you don't want the money, you can always disclaim (refuse to accept) the inherited IRA or plan funds. But if you're like most people, you will want the money. Your first thought may be to take a lump-sum distribution, but that's usually not the best idea. Although a lump sum provides you with cash to meet expenses or invest elsewhere, it can also result in a huge income tax bill (in most cases, due all in one year). A lump-sum distribution also removes the funds from a tax-deferred environment. Fortunately, you probably have other alternatives. If you are the designated beneficiary (i.e., you are named as beneficiary in the IRA or plan documents), you can take post-death distributions over your remaining life expectancy, spreading out distributions over a number of years. This life expectancy calculation will give you the minimum amount you must withdraw from the IRA or plan each year (you can always withdraw more than required in any year). Yearly distributions from the IRA or plan must begin by December 31 of the year following the year of the owner's or participant's death. If there are other designated beneficiaries and separate accounts have not been set up, the oldest beneficiary must be used for the life expectancy calculation. (Note: An employer-sponsored retirement plan can specify the distribution method that beneficiaries must use.) You may have other options as well. If the IRA owner or plan participant died before he or she began taking required minimum distributions, you can generally elect to distribute the entire interest in the IRA or plan within five years of the owner's or participant's death. (In this case, you don't have to begin taking distributions the year after death.) If the IRA owner or plan participant died after beginning to take required minimum distributions, you may be able to spread distributions over the owner's or participant's remaining life expectancy (calculated in the year of death) if that period is longer than your own life expectancy. Be careful, though. Again, however, keep in mind that an employer-sponsored retirement plan can specify the distribution method that beneficiaries must use. If your choices are limited by a plan, you may have the ability to transfer the plan funds to an IRA established in the 1

2 deceased IRA owner's or plan participant's name--the rules that apply to inherited IRAs would apply to the transferred funds. You may also have additional options if you are a surviving spouse and a designated beneficiary of the IRA or plan. You can roll over inherited traditional IRA or plan funds into your own traditional IRA or retirement plan. If you're the sole beneficiary you can also leave the funds in an inherited IRA and treat it as your own IRA. In either case you can then name beneficiaries of your choice and defer taking distributions until the required age (usually 70½). You can generally also roll over ("convert") non-roth distributions from an employer plan into a Roth IRA (you'll generally pay tax upon the "conversion" but qualified distributions from the Roth IRA will be tax free). If you're a non-spouse beneficiary, you generally have far fewer options. For example, you can't roll over a distribution from an employer retirement plan into your own IRA but you can generally directly roll the distribution over into an inherited IRA. Like spouse beneficiaries, you can also roll over ("convert") non-roth distributions from an employer plan into a Roth IRA (however, you must do so in a direct rollover). Certain restrictions apply to rollovers, however. For example, you cannot roll over required minimum distribution amounts (i.e., distributions required in the year of death). Also, inherited Roth IRAs can only be rolled over into a Roth IRA, and inherited Roth 401(k)/403(b)/457(b) accounts can only be rolled into another Roth 401(k)/403(b)/457(b) account that accepts rollovers, or into Roth IRAs. Finally, Roth IRAs are subject to different rules. If you inherit a Roth IRA, you can take distributions over a five-year period (following the Roth IRA owner's death) or over your remaining life expectancy. If you are a surviving spouse beneficiary, you may be able roll the assets over to your own Roth IRA or, if you're the sole beneficiary, treat the Roth IRA as your own. This is significant because, as a Roth IRA owner, you do not have to take any distributions from the Roth IRA during your life. Distributions from an inherited Roth IRA are usually free from income tax if made at least five years after the first contribution to the Roth IRA. The rules governing inherited IRAs and employer-sponsored plan accounts are complex. Consult a tax advisor for more information. What is it? The five-year rule is a method of taking post-death required minimum distributions from Withdraw the Entire Amount of an Inherited IRA or Retirement Plan within Five Years (Five- Year Rule) an IRA or an employer-sponsored retirement plan account. Under this method, the IRA or plan beneficiary must receive the entire balance of the inherited account within a five-year period. The five-year period ends on December 31 of the calendar year that contains the fifth anniversary of the IRA owner's or plan participant's death. For example, if a participant died on January 1, 2010, the entire interest must be distributed by December 31, Distributions may be taken in any amount and at any time within the five years. However, if any funds remain in the IRA or plan after the five-year period has passed, those funds will generally be subject to a 50 percent federal penalty tax. 2

3 Tip: Employer-sponsored retirement plans that are subject to the required minimum distribution rules are qualified plans (including 401(k), profit-sharing, stock bonus, and defined benefit plans), 403(b) plans, 457(b) plans, SEPs, and SIMPLE plans. When does the five-year rule apply? IRS regulations provide that the five-year rule is the default method of payout when there is no designated beneficiary, and the account owner's death occurs before his or her required beginning date. If the IRA owner or plan participant dies with one or more designated beneficiaries (i.e., individuals named as beneficiaries), or on or after the required beginning date, the default method of payout is instead the life expectancy method. However, there are additional situations in which the five-year rule may apply: 1. The IRA or retirement plan requires you to use the five-year rule. Even though the life expectancy method is the default payout method when the IRA owner or plan participant names an individual as designated beneficiary, the terms of the IRA or plan may be less liberal than the law allows, and may require that you take post-death distributions under the five-year rule if the IRA owner or plan participant dies before his or her required beginning date. Consult the IRA custodian/trustee or plan administrator regarding your post-death options. 2. You fail to start installments under the life expectancy method on a timely basis. If you want to take post-death distributions using the life expectancy payout method, the distributions generally must begin no later than December 31 of the year following the year of the IRA owner's or plan participant's death. If the distributions do not begin on or before that date, the five-year rule becomes the default method of payout, and you are no longer allowed to use the life expectancy method. 3. You choose to use the five-year rule. An IRA or retirement plan may allow the designated beneficiary to elect to use either the life expectancy method or the five-year rule. Why choose the five-year rule? In most cases it will not be in your best interest to take distributions from an inherited IRA or plan under the five-year rule. That is because other post-death distribution options are usually available, and these options often provide greater tax benefits and other advantages. For example, if the life expectancy method is the default payout method (or available as an alternative), this method will typically allow post-death distributions to be taken over a longer period than the five-year rule. This will also likely be the case if you are a surviving spouse beneficiary, and you are able to roll over the inherited funds to your own IRA. A longer payout period is beneficial because it maximizes the funds' tax-deferred growth potential, and spreads out your income tax liability on those funds over more years. By contrast, under the five-year rule, the maximum possible payout period for post-death distributions will be five years. Taking your post-death distributions over a five-year period could result in a significant income tax liability for some or all of those five years. This is particularly true if you are in a high income tax bracket and/or there are substantial funds in the inherited IRA or plan. Finally, a five-year payout period does not allow much time for the inherited funds to continue growing tax deferred. However, there are certain situations in which it may make sense to take post-death distributions using the five-year rule. Consider the following scenario. 3

4 Example(s): Elaine wants to buy a house in four years. She has recently inherited a traditional IRA from her friend Cal. She could withdraw the entire balance of the IRA now, pay applicable taxes on the distribution, and use the funds to buy the house in four years. But this would cause her to lose a large portion of the funds to taxes. Elaine could also take post-death distributions over her life expectancy, but then she would have to take annual distributions for four years before withdrawing the balance to buy a house. Under the five-year rule, Elaine can keep all of the money in the inherited IRA until she needs it to buy a house in four years. In the meantime, the funds will continue to grow tax deferred in the IRA. In this case, the flexibility to take distributions in any amount and at any time within the five-year period is well suited to Elaine's needs. How to do it As an IRA or retirement plan beneficiary, you will need to contact the IRA custodian or plan administrator to determine your options and to request the necessary form for distribution. Return the form along with any required documentation (such as identification and a death certificate), indicating that you want to take post-death distributions under the five-year rule. Keep in mind that this may be the default method of payout in some cases. Non-spouse rollover from an employer plan to an inherited IRA--The Pension Protection Act of 2006 A spouse beneficiary can roll over death benefits received from an employer-sponsored retirement plan to either the spouse's own IRA, or to an IRA established in the deceased's name with the spouse as beneficiary (an "inherited IRA"). In the past, neither of these options was available to non-spouse beneficiaries. While non-spouse beneficiaries still cannot roll over inherited funds from an employer plan to their own IRA, the Pension Protection Act of 2006 lets non-spouse beneficiaries make direct (trustee to trustee) rollovers from qualified plans (including 401(k)s), 403(b), and governmental 457(b) plans to inherited IRAs. If a non-spouse beneficiary elects a direct rollover, the amount directly rolled over is not includible in gross income in the year of the distribution. The ability to make a rollover to an IRA is significant because employer plans often require faster payouts to non-spouse beneficiaries than the law requires, accelerating taxation for these individuals. IRAs on the other hand generally allow distributions to be spread over the maximum period permitted by law, permitting tax deferral for the longest period of time. The IRS has provided guidance on non-spouse rollovers from employer sponsored plans to IRAs in IRS Notice The Notice provides that: The IRA must be established in a manner that identifies it as an inherited IRA, and also identifies the deceased employee and the beneficiary, for example, "Tom Smith as beneficiary of John Smith." An indirect rollover--where the beneficiary receives the distribution and then rolls the funds over to an IRA within 60 days--is not allowed. A plan can make a direct rollover to an IRA on behalf of a trust where the trust is the deceased employee's named beneficiary, provided the beneficiaries of the trust can be treated as designated beneficiaries under IRS required minimum distribution (RMD) rules, and the trust is identified as the IRA beneficiary. The non-spouse beneficiary can't roll over RMDs to the inherited IRA. The Notice provides complex rules for determining both the RMDs ineligible for rollover from the employer plan, and the RMDs required from the IRA after the rollover: 4

5 1. The employee dies before his or her required beginning date, and the five-year rule applies. Under the five-year rule, no amount has to be distributed by the retirement plan to the beneficiary until the end of the fifth calendar year following the year of the employee's death. In that year, the entire remaining amount that the beneficiary is entitled to under the plan must be distributed. Notice provides that the beneficiary can directly roll over his or her entire benefit until the end of the fourth year. On or after January 1 of the fifth year following the year in which the employee died, no amount payable to the beneficiary is eligible for rollover. Most importantly, Notice provides that if the beneficiary was subject to the five-year rule in the employer plan, the five-year rule will continue to apply to for purposes of determining RMDs from the inherited IRA after the rollover. However, even where the five-year rule applies, a special rule allows a non-spouse beneficiary to determine the RMD under the employer plan using the life expectancy rule, roll the balance over to an inherited IRA, and continue to take RMDs from the IRA using the life expectancy rule--which provides the maximum tax deferral for the beneficiary. To use this special rule the rollover must occur no later than the end of the year following the year in which the employee dies. Example(s): Sam, a participant in his employer's 401(k) plan, dies on June 1, The 401(k) plan provides that beneficiaries must receive their entire balance from the plan under the five year rule. Therefore June, Sam's beneficiary, must receive the entire balance no later than December 31, June would like to defer taxes on her inherited funds for as long as possible. If she makes a direct rollover to an inherited IRA by December 31, 2014, she will be able to use the life expectancy rule, rather than the five-year rule, when calculating her RMDs from the IRA. Her rollover must be reduced by the amount of RMDs that would have been required under the employer plan using the life expectancy rule. If June fails to make her rollover by December 31, 2014, then she will still be able to make a rollover to an inherited IRA (no later than December 31, 2017), but will have to continue to use the five-year rule when calculating her RMDs from the IRA. That is, she will still be required to receive all the funds in the inherited IRA no later than December 31, The employee dies before his or her required beginning date, and the life expectancy rule applies. If the life expectancy rule applies, the amount ineligible for rollover includes all undistributed RMDs for the year in which the direct rollover occurs and any prior year. After the rollover, the life expectancy rule continues to apply in determining RMDs from the inherited IRA. RMDs are determined using the same applicable distribution period as would have been used under the employer plan if the direct rollover had not occurred. 3. The employee dies on or after his or her required beginning date. If an employee dies on or after his or her required beginning date, the amount ineligible for rollover includes all undistributed RMDs for the year in which the direct rollover occurs and any prior year, including years before the employee's death. After the rollover, the life expectancy rule continues to apply in determining RMDs from the inherited IRA. The RMD under the IRA for any year after the employee's death must be determined using the same applicable distribution period as would have been used under the employer plan if the direct rollover had not occurred. 5

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