Originally Published: June 2012 Updated: August 2015!!

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1 Updated: August 2015 This educational publication is designed to provide a background for understanding the use of Individual Retirement Accounts (IRAs). It is not a substitute for professional tax advice. Readers considering the implementation of an IRA are encouraged to discuss and review their specific plans with a financial advisor and/or tax professional. Good financial advice can save you money and headaches. True Vine Investments will not be held responsible for negative implications arising from the use of the information presented. Interested readers are encouraged to obtain Publication 590-A and 590-B from the Internal Revenue Service, which covers the specifics of Individual Retirement Arrangements (IRAs) and Publication 575, which covers the taxation of pension and annuity distributions. Many of us already have, or will end up being, on the giving or receiving end of an inherited retirement account during our lifetime. As we examine how the process works, I will point out many caveats to be aware of so that (1) if and when you do inherit you will have detailed knowledge of the process and (2) at present you can make sure your retirement account is structured in the most beneficial way for your heirs. By beneficial, I am specifically referring to your heirs being able to extend their inherited account for the longest amount of time. The longer the funds remain invested in the taxdeferred inherited account, the greater the overall benefit will be for them and their heirs. In this guide I will only mention IRAs ( Individual Retirement Accounts ), however, please note that I am generally referring to all types of pre-tax retirement plans (income tax not yet paid on the amounts). Any important exceptions that apply only to non-ira retirement plans (e.g., 401(k) or 403(b)) will be specifically mentioned. This guide does not mention Roth IRAs, however, the same rules apply for inheriting them, except distributions are usually not taxable. The only exception is if the owner s Roth was less than 5 years old, in which case the earnings portion of distributions are taxable. Make sure you have selected beneficiaries for all your own retirement plan accounts. If you are not sure, call the administrator for each one and request a copy of your beneficiaries. This is very important. Significant tax advantages will be lost for your heirs if you do not elect beneficiaries for your accounts. It is important to understand the concept of designated beneficiaries. The owner of an IRA can name any person or entity as beneficiary, but not all beneficiaries are designated beneficiaries. Only a natural person (spouse or nonspouse) or a qualified trust is considered to be a designated beneficiary. An estate, charity, corporation, or nonqualified trust is not considered to be a designated beneficiary. If you do not select a beneficiary for your IRA, you generally will be deemed to have no designated beneficiary. If a beneficiary you select for your IRA is not considered to be a designated beneficiary, you are deemed to have no beneficiary at all for required minimum distribution purposes. This means the beneficiary will have to take distributions from their inherited account at a faster pace, which reduces the long-term advantages of tax deferred compounding for them. 1

2 Updated: August 2015 If any one of the primary beneficiaries of your IRA fails to qualify as a designated beneficiary, then you are deemed to have no designated beneficiary at all. For example, if you name your spouse as a 50% beneficiary and a charity as a 50% beneficiary of your IRA, you are deemed to have no designated beneficiary, because the charity is not a natural person. If you must name a charity as an IRA beneficiary, you can avoid this problem by setting up a separate IRA and transferring half of your IRA assets into it. Your spouse should be named the sole primary beneficiary of one of the IRAs and the charity the sole primary beneficiary of the other. Most people usually select their spouse as primary beneficiary and their children as contingent beneficiaries. This type of standard arrangement will not have any negative consequences. What to do First if you Inherit a Retirement Plan When you find out that you have inherited a retirement plan a good first step is to get several copies of the following documents right away: 1. the death certificate 2. the beneficiary form (from the retirement account) 3. the most recent account statement If you have to contact the financial institution that administers the plan to get the 2nd and 3rd documents, do not make any decisions right away on how to handle the plan, if they ask you. Read this guide first and review the decision with your financial adviser. If it is not structured properly it could end up costing you thousands of dollars in taxes, depending upon your situation. Important IRS Terms and Definitions RMD - Required Minimum Distributions = The IRS requires IRA owners to begin taking minimum distributions from their accounts on an annual basis after they reach age 701/2. If you want to learn more about required minimum distributions ( RMD ), refer to my publication: Understanding IRAs - Required Distributions, available at or me and I ll send you a copy. Nonspouse beneficiaries of IRAs are required to begin taking minimum distributions in the year following the death of the owner. It is important to take your RMDs when required because the amount is subject to a 50% tax if you miss it. This guide gives you all the details you need to ensure that doesn t happen. 2

3 Updated: August 2015 RBD - Required Beginning Date = The RBD is April 1 of the year after a person turned 701/2 (this sort of things is a good example of why the federal tax system is out of control and needs to be simplified). This is the deadline for taking your first required distribution. I find it easier to just know that you must take your first distribution in the year you reach age 701/2 (although since the deadline is actually April 1 of the following year, you essentially have 15 months to take the first one). You will need to know if the original owner died before or after this date. ADP - Applicable Distribution Period = ADP is the life expectancy factor used to calculate RMDs. I recommend ordering Publication 590-B from the IRS (it s free) at 0,,id=10768,00.html or, if you prefer, access it online at The Life Expectancy Tables needed to find your ADP to make your RMD calculations are in the back in Appendix B. Guidelines for an Inheriting Spouse who is the Sole Beneficiary If you are a spouse who inherits an IRA, where you are the sole beneficiary, you have the following two options: 1. Remain as the beneficiary instead of treating it as your own (leaving the account in the name of the deceased spouse). This may be an attractive option if you are under the age of 591/2 and have to withdrawal some or all of the funds to pay expenses, because the 10% early distribution penalty does not apply to beneficiaries taking distributions. If you are not sure if you will need to use some of the funds before you are 591/2, you can remain the beneficiary until that age and then initiate a rollover into your own IRA upon reaching 591/2 (if you did not make any withdrawals). This may also be a good option if you are older than your deceased spouse, because you can wait until they would have been 701/2 to begin taking the mandatory RMDs. I recommend avoiding this option and using the 2nd one below if you are (1) younger than 591/2, (2) younger than your deceased spouse, and (3) will definitely not need to withdrawal any of the funds prior to age 591/2. I recommend avoiding this option and using the 2nd one below if you are (1) older than 591/2 and (2) younger than your deceased spouse. 3

4 Updated: August 2015 If you do decide to use this option and remain as the beneficiary, RMDs must be taken according to one of the following options: a. If the deceased spouse died before their RBD, the inheriting spouse can wait to begin taking RMDs until the year the deceased spouse would have reached 701/2 (even if the inheriting spouse is over age 701/2). Once the year arrives in which the deceased spouse would have turned 701/2, use the following steps to calculate the RMD amount: i. Find the retirement account balance as of December 31 of the year before the deceased spouse would have turned 701/2. ii. Go to the IRS Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B, available online at: Look up the Life Expectancy factor using your attained age in the year your deceased spouse would have turned 701/2 (this is your ADP). iii. Divide the account balance by the ADP (step 1 divided by step 2) to determine the RMD. This amount must be withdrawn from the account by December 31 of the year the deceased spouse would have turned 701/2. iv. For all subsequent years, the living spouse would continue to calculate the RMD by dividing the account balance as of December 31 of the previous year by the new ADP (the Life Expectancy factor corresponding to the age of the living spouse for that year). b. If your spouse died on or after their RBD, you must take your first distribution before December 31 of the year after the death of your spouse. If your spouse did not take their regular RMD for the year of death, the inheriting spouse must take it on their behalf before December 31 of that year (For details on how to calculate the deceased spouse s RMD, refer to my publication: Understanding IRAs - Required Distributions, available at education.html). Use the following steps to calculate the RMD you must take each year after your deceased spouse s death: i. Find the retirement account balance as of December 31 of the previous year. The first time you do this, you will use the account balance as of December 31 of the year your spouse died. ii. Go to the IRS Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B, available online at: (a) If you are younger than your deceased spouse, look up the Life Expectancy factor using your attained age in the current year (this is the ADP). 4

5 Updated: August 2015 (b) If you are older than your deceased spouse, the ADP is determined by using the greater of the following two Life Expectancy factors: Deceased spouse s life expectancy at the time of death, reduced by one for each subsequent year Your life expectancy, using your attained age in the current year (c) Note that using the greater factor is to your advantage, because it will reduce the size of your RMD, allowing you to stretch the tax-deferred growth of your account further. iii. Divide the account balance by the ADP (step 1 divided by step 2) to determine your RMD. This amount must be withdrawn from the account by December 31 of the current year. 2. Treat it as your own by rolling it over into an IRA or another retirement plan in your own name. If you are younger than age 591/2, I recommend this option if you are younger than your deceased spouse and will definitely not need to withdraw any of the funds prior to attaining age 591/2. If you are older than age 591/2, I recommend this option if you are younger than your deceased spouse. If you decide to use this option and roll it over into your own IRA, the account will then become your own, just as if you were the original owner. Make absolutely sure you have elected beneficiaries for your IRA to ensure your heirs receive the best possible tax treatment under the law. Note that you must begin taking RMDs the year you reach age 701/2. For details on how to calculate your RMD, refer to my publication: Understanding IRAs - Required Distributions, available at Guidelines for a Sole Beneficiary who is not the Spouse If you are the sole nonspouse beneficiary of a retirement plan that is not an IRA (e.g., a 401(k)), then take the following steps: 1. If you are younger than 591/2 you can take distributions from the account without paying the 10% early withdrawal penalty, but you will have to pay income tax on the distribution. The 10% early withdrawal penalty never applies to a beneficiary. Unless you absolutely need the funds, I recommend leaving them in the account or rolling them into an inherited IRA (explained below) to take advantage of the tax deferral. 5

6 Updated: August The first thing you will want to do is read the plan documents to see what its rules are. The plan may require that benefits be paid out within five years. If the plan requires the five-year rule, see if there is an exception that allows you to transfer the assets into an inherited IRA instead. If the plan documents don t mention the exception, call them to see if you can do a transfer to an inherited IRA. There are significant tax advantages available if you can transfer the assets to an inherited IRA, so make absolutely sure you cannot before submitting to the five-year rule requirements. If the plan doesn t mention the five-year requirement, then you can distribute the funds over your lifetime, although you may have to keep the assets in the plan (as opposed to transferring them to an inherited IRA you establish). 3. Assuming you can and do decide to take distributions over your lifetime you can leave the assets in the plan or usually, depending upon the plan rules transfer them to an inherited IRA you establish. I generally recommend transferring the funds to an inherited IRA, because you will have more investment options available. The plan you inherit may have some unique investment options available to you that you otherwise would not have access to, but that is a rare exception. 4. If the deceased owner died after their RBD, see if they took their RMD for the year of death. If not, have the required amount distributed to yourself as beneficiary before December 31 of the year of their death. 5. If you decide to leave the funds in the retirement plan, skip to #7 below. 6. If you decide to transfer the funds to an inherited IRA, make sure you do the following: a. Open a new inherited IRA with your desired financial institution. You cannot use an IRA you already have from a different inheritance. However, you can use the same inherited IRA to combine assets inherited from the same person, as long as it is titled properly (see below) with your social security number. b. Request a direct transfer (trustee-to-trustee transfer) from the retirement plan to your newly established inherited IRA. A direct transfer is just what it implies the funds move directly from the retirement plan to the IRA and you don t touch it. As a nonspouse beneficiary you cannot do a rollover. The direct transfer from the retirement plan to the IRA is essential, because if a check is sent to you (with the intention of rolling it over), you will owe income tax on the entire amount c. Title the inherited IRA to include your name as well as the name of the deceased owner. A good format to use is the following: [name of deceased], (deceased, date of death) IRA FBO [name of beneficiary], Beneficiary 6

7 Updated: August 2015 For example, assuming you are Michael Thomas and your father, Paul, died on April 15, 2012, leaving you his entire 401(k) that you transferred to an inherited IRA: Paul Thomas, (deceased, April 15, 2012) IRA FBO Michael Thomas, Beneficiary *The account must be titled like this to ensure it is clearly recognized as an inherited one. d. The social security number on the inherited IRA should be yours. e. Select beneficiaries for the account upon opening it. Do not put this off If there are no beneficiaries listed on the account your heirs will lose the valuable tax deferral advantages. f. It is critical to note that if you just transfer the funds to an IRA in your own name that you will owe income tax on the entire amount and there is no reversing this By not titling the inherited IRA properly you will have lost the opportunity for extended tax deferral and, depending upon the size of the account, may owe a substantial amount of income taxes. 7. You must begin taking RMDs by December 31 in the year after the original owner s death. Your RMD is calculated by doing the following: a. Find the account balance as of December 31 in the year of the original owner s death. b. Go to the IRS Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B, available online at: and look up your Life Expectancy factor using your attained age in the current year (this is the ADP). c. Divide the account balance by the ADP (step 1 divided by step 2) to get your RMD for the first year. d. In subsequent years your RMD is calculated by taking the account balance as of December 31 of the previous year divided by your ADP from the first year reduced by one for each year since the year following the original owner s death. i. For example, assume you are 50 years old in 2012, the original owner died in 2011, and the account balance on December 31 was $100,000, then your RMD would be $2, ($100,000 / 34.2). If the balance was $110,000 on December 31, 2012, then your RMD for 2013 would be $3, ($110,000 / 33.2). If the balance was $90,000 on December 31, 2013, then your RMD for 2014 would be $2, ($90,000 / 32.2). 8. Remember, the RMD is the minimum amount you have to take out each year. You can always take out more if you want. 7

8 Updated: August 2015 If you are the sole nonspouse beneficiary of an IRA, then take the following steps: 1. If you are younger than 591/2 you can take distributions from the account without paying the 10% early withdrawal penalty, but you will have to pay income tax on the distribution. The 10% early withdrawal penalty never applies to a beneficiary. Unless you absolutely need the funds, I recommend leaving them in the account or rolling them into an inherited IRA (explained below) to take advantage of the tax deferral. 2. If the deceased owner died after their RBD, see if they took their RMD for the year of death. If not, have the required amount distributed to yourself as beneficiary before December 31 of the year of their death. 3. Change the account title of the IRA to include your name as well as the name of the deceased owner. A good format to use is the following: [name of deceased], (deceased, date of death) IRA FBO [name of beneficiary], Beneficiary For example, assuming you are Michael Thomas and your father, Paul, died on April 15, 2012, leaving you his entire 401(k) that you transferred to an inherited IRA: Paul Thomas, (deceased, April 15, 2012) IRA FBO Michael Thomas, Beneficiary *The account must be titled like this to ensure it is clearly recognized as an inherited one. 4. Change the social security number on the IRA to your own. 5. Immediately select beneficiaries for your new inherited IRA. Do not put this off If there are no beneficiaries listed on the account your heirs will lose the valuable tax deferral advantages. 6. You can hold the inherited IRA with a different financial institution if you want. Open a new inherited IRA with the desired institution titled exactly the same (as outlined above) with your social security number on the account and select your beneficiaries. Request a direct transfer of the funds from the IRA at the previous owner s institution to the new inherited IRA you opened with your institution. It is critical to note that if you transfer the funds to an IRA in just your own name, you will owe income tax on the entire amount and there is no reversing this By not titling the new inherited IRA properly you will have lost the opportunity for extended tax deferral and, depending upon the size of the account, may owe a substantial amount of income taxes. 7. You must begin taking RMDs by December 31 in the year after the original owner s death. Your RMD is calculated by doing the following: a. Find the account balance as of December 31 in the year of the original owner s death. 8

9 Updated: August 2015 b. Go to the IRS Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B, available online at: and look up your Life Expectancy factor using your attained age in the current year (this is the ADP). c. Divide the account balance by the ADP (step 1 divided by step 2) to get your RMD for the first year. d. In subsequent years your RMD is calculated by taking the account balance as of December 31 of the previous year divided by your ADP from the first year reduced by one for each year since the year following the original owner s death. i. For example, assume you are 50 years old in 2012, the original owner died in 2011, and the account balance on December 31 was $100,000, then your RMD would be $2, ($100,000 / 34.2). If the balance was $110,000 on December 31, 2012, then your RMD for 2013 would be $3, ($110,000 / 33.2). If the balance was $90,000 on December 31, 2013, then your RMD for 2014 would be $2, ($90,000 / 32.2). 7. The RMD is the minimum amount you have to take out each year. You can always take out more if you want. Guidelines for Multiple Beneficiaries Inheriting One Account - Splitting the Account (assuming all are designated beneficiaries) 1. Before splitting the account, the beneficiaries should determine if the deceased owner died after their RBD, and if so, if they took their RMD for the year of death. If they died after their RBD and did not take their RMD, have the required amount distributed to the beneficiaries before December 31 of the year of death. The distribution should be divided evenly amongst the beneficiaries. However, if one beneficiary just wants to cash out his inheritance, the RMD for the original owner can be applied against this withdrawal and the other beneficiaries will not have to take a portion of the RMD distribution. 2. The beneficiaries should work with the custodian (financial institution holding the account) and notify them of their intention to split the original account into separate accounts for each beneficiary. This allows each beneficiary to manage their own investments, provides for simpler accounting, and ensures that all beneficiaries receive the best possible tax treatment under the law. You should do this right away before December 31 of the year of death, if possible because there are tax advantages for the youngest beneficiaries. The deadline for splitting the account is December 31 of the year after the owner s death. 3. The separate accounts can reside with the same custodian or, if preferred, beneficiaries can open up accounts with different custodians and have their portion of the assets transferred there. 9

10 Updated: August The new inherited IRA accounts for nonspouse beneficiaries must remain in the name of the deceased. Make sure your new account custodian titles the account to include your name as well as the name of the deceased owner. A good format to use is the following: [name of deceased], (deceased, date of death) IRA FBO [name of beneficiary], Beneficiary For example, assuming you are Michael Thomas and your father, Paul, died on April 15, 2012, leaving you a portion of his 401(k) that you transferred to an inherited IRA: Paul Thomas, (deceased, April 15, 2012) IRA FBO Michael Thomas, Beneficiary *The account must be titled like this to ensure it is clearly recognized as an inherited one. 5. Make sure the social security number on each of the new inherited IRA accounts is that of the beneficiary. Change it if it is still that of the original owner. 6. Beneficiaries with new Inherited IRAs should elect successor beneficiaries for their accounts immediately. Do not put this off If there are no beneficiaries listed on the account, the heirs will lose the valuable tax deferral advantages. 7. When moving funds to newly established inherited IRAs with different custodians, make sure that they are only moved by a trustee-to-trustee transfer (custodian-to-custodian transfer is the same thing). This is where the funds are not withdrawn or touched by the beneficiaries at all. Nonspouse beneficiaries cannot do a rollover, so that is not an option either. If the funds are withdrawn, in order to be deposited into new separate inherited accounts for the beneficiaries, the tax deferral is voided and income tax will be due on the entire amount The IRS considers the assets to have been withdrawn and taxable for that year if a beneficiary had control of the funds at any time. Also, it is critical to note that if you transfer the funds to an IRA in just your own name, you will owe income tax on the entire amount and there is no reversing this By not titling the new inherited IRA properly you will have lost the opportunity for extended tax deferral and, depending upon the size of the account, may owe a substantial amount of income taxes. 8. If you are younger than 591/2 you can take distributions from the account without paying the 10% early withdrawal penalty, but you will have to pay income tax on the distribution. The 10% early withdrawal penalty never applies to a beneficiary. Unless you absolutely need the funds, I recommend leaving them in the inherited IRA to take advantage of the tax deferral. 9. You must begin taking RMDs by December 31 in the year after the original owner s death. Your RMD is calculated by doing the following: a. Find the account balance as of December 31 in the year of the original owner s death. 10

11 Updated: August 2015 b. Go to the IRS Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B, available online at: and look up your Life Expectancy factor using your attained age in the current year (this is the ADP). c. Divide the account balance by the ADP (step 1 divided by step 2) to get your RMD for the first year. d. In subsequent years your RMD is calculated by taking the account balance as of December 31 of the previous year divided by your ADP from the first year reduced by one for each year since the year following the original owner s death. i. For example, assume you are 50 years old in 2012, the original owner died in 2011, and the account balance on December 31 was $100,000, then your RMD would be $2, ($100,000 / 34.2). If the balance was $110,000 on December 31, 2012, then your RMD for 2013 would be $3, ($110,000 / 33.2). If the balance was $90,000 on December 31, 2013, then your RMD for 2014 would be $2, ($90,000 / 32.2). 10. The RMD is the minimum amount you have to take out each year. You can always take out more if you want. 11