Did you know you could roll over your 401(k) into an annuity? I didn’t know but I am looking at how it’s done. When I get that I will tell you the secret on doing it. In the meantime here is an interesting article for Investopedia.
When you are named the beneficiary of an Individual Retirement Account (IRA) and the IRA owner dies, you may think you’ve received a tax-free inheritance. Well, that’s only partially correct. Under current tax law, the receipt of the inheritance is tax-free, but you are still required to take distributions from the account, which may well be taxable. Taxation depends on the type of IRA involved.
KEY TAKEAWAYS
Individual retirement account assets are passed to the named beneficiaries, often the person’s spouse, upon death.
While the receipt of these funds is often tax-free, beneficiaries may be required to take required minimum distributions (RMDs), which can be taxable.
Failure to take RMDs in a timely manner can result in penalties of up to 50%.
You Inherit an IRA: What Happens Next?
When you inherit an IRA, you are free to take as much of the account as you want at any time, so long as you satisfy the required minimum distribution (RMD) rules discussed below. You can also take out all of the funds at once if you prefer.
If the IRA is a traditional IRA to which all contributions were tax-deductible, you’ll pay income tax on your distributions, but there’s no early distribution penalty even if you and/or the owner are under age 59½. If you inherit a traditional IRA to which both deductible and nondeductible contributions were made, part of each distribution is taxable.
If you inherit a Roth IRA, it is completely tax-free if the owner held any Roth IRAs for at least five years (starting Jan. 1 of the year in which the first Roth IRA contribution was made). If you receive distributions from the Roth IRA before the end of the five-year holding period, they are tax-free to the extent that they represent a recovery of the owner’s contributions and taxable to the extent they are allocable to earnings.
Required Minimum Distributions
Regardless of the type of IRA you inherit, you must generally take out at least a minimum annual amount over a certain period; these mandatory withdrawals are called required minimum distributions (RMDs). If you fail to, you can be subject to a whopping 50% penalty on the amount you should have withdrawn. Note that the rules for spouses who inherit an IRA are somewhat different, as explained below.
RMDs are designed to eventually exhaust the funds in the account so that tax-deferred, or in the case of Roth IRAs, tax-free, accumulations won’t last forever. There are two RMD methods:
You can postpone any distributions as long as you empty the account by the end of the fifth year of death (called the five-year rule). For example, a parent dies in April 2020, leaving an IRA to their daughter. If the daughter uses this method, all of the funds must be withdrawn by Dec. 31, 2025.
You take RMDs over life expectancy. Use your own life expectancy if the original IRA owner was not at least 70½ and taking RMDs. This means applying the life expectancy for your age found in the Single Life Expectancy Table (Table I in Appendix B of IRS Publication 590-B). If the owner was already taking RMDs, use the longer of your single life expectancy or the owner’s life expectancy, based on the owner’s age on their birthday in the year of their death). Thus, if you inherit an IRA from your younger sister, using her life expectancy produces smaller RMDs (remember that you can always take larger distributions if you want the funds).
“Clients overwhelmingly choose to convert to an Inherited IRA and take life expectancy payments,” says retirement-planning expert Stephen Rischall, co-founder of 1080 Financial Group in Sherman Oaks, Calif. “I’ve had fewer than 10% of beneficiaries choose a lump sum, and never had a client choose the five-year option.”
The RMD rules for beneficiaries do not eliminate the need for the deceased owner’s estate to take his or her RMD for the year of death if the owner died on or after attaining age 70½. The RMD for the owner reduces the account value on which the RMD for the beneficiary is figured.
Let’s suppose an IRA holder, Tom, dies in 2019. If Tom was required to take an RMD for 2019 (and did not do so before he died), his beneficiaries are required to withdraw that amount by Dec. 31, 2019. The payer is required to report the amount under the beneficiary’s tax identification number, and the beneficiary must include the amount in his or her income. Bear in mind also that the amount is calculated as if the IRA owner (Tom) had been alive for all of 2019.
When you inherit an IRA, make sure that the title to the account conforms to tax law. If you are a non-spouse beneficiary, do not put the account in your own name. The account title should read: “[Owner’s name], deceased [date of death], IRA FBO [your name], Beneficiary” (FBO means “for the benefit of”). If you put the account in your name, this is treated as a distribution, and all of the funds are immediately reported. It’s very difficult to undo this error.
Special Rules for Surviving Spouses
If you are the surviving spouse of an IRA owner and are the sole beneficiary of the IRA, you have a choice:
You can act like any other beneficiary, as explained earlier. However, if your spouse died before the year of his or her 70½ birthday, you do not have to start receiving RMDs until that year. “If your deceased spouse was younger, choosing an inherited IRA may be beneficial because it delays RMDs to when the younger deceased spouse would have turned 70½,” says Rischall.
You can treat the account as your own by naming yourself as the account owner or by rolling over the IRA into your own account. This enables you to make contributions to the account if you are eligible (e.g., you have earned income and are under age 70½, in the case of a traditional IRA), to name your own beneficiaries, and to postpone RMDs until you reach age 70½, again in the case of a traditional IRA. This is a good choice if your spouse was older than you are because it delays the RMDs. If the IRA was a Roth, because you are the spouse you can treat it as if it had been your own Roth all along, in which case you won’t be subject to RMDs during your lifetime.
This is not an all-or-nothing decision. You can parse the account and roll over some of it to your own IRA and leave the balance in the account you inherited. However, there’s no changing your mind. If you make a rollover and need funds from it before age 59½, you’ll be subject to the 10% penalty (unless some penalty exception other than death applies).
Special IRA Transfer Rule
If you are age 70½ or older, you can transfer up to $100,000 from an IRA directly to a qualified charity. The transfer, which is called a qualified charitable distribution (QCD) even though no tax deduction is allowed, is tax-free and can include RMDs (i.e., they become non-taxed). This tax break was made permanent by the Consolidated Appropriations Act of 2016, which became law on Dec. 18, 2015.
Handling Tax Issues
When taking RMDs from a traditional IRA, you will have income taxes to report. You’ll receive Form 1099-R showing the amount of the distribution. You must then report in on your Form 1040 or 1040A for the year; if you receive a distribution, you cannot use Form 1040EZ, even though you might otherwise be eligible to do so.
If the distribution is sizable, you may need to adjust your wage withholding or pay estimated taxes to account for the tax that you’ll owe on the RMDs. These distributions, which are called nonperiodic distributions, are subject to an automatic 10% withholding unless you opt for no withholding by filing Form W-4P.
If the IRA owner died with a large estate on which federal estate taxes were paid, as the beneficiary you are entitled to a tax deduction for the share of these taxes allocable to the IRA. The federal income tax deduction for federal estate tax on income in respect of a decedent (such as an IRA) is a miscellaneous itemized deduction (you can’t claim it if you use the standard deduction instead of itemizing), but it is not subject to the 2%-of-adjusted-gross-income threshold applicable to most other miscellaneous itemized deductions.
The Bottom Line
Inheriting an IRA is a blessing and a bit of curse. You obtain an asset that costs you nothing, and the asset can continue to grow. However, you’ll face a tax bill if the asset is a taxable IRA. You cannot avoid this because the law requires you to take RMDs or face a 50% penalty. Check with the custodian or trustee of the IRA for the amount and timing of your RMDs. Also, work with a knowledgeable tax advisor to ensure that you meet the RMD requirements.
By BARBARA WELTMAN
R. LaMont W.
