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By Emmy Hernandez
Tell me if you’ve heard this one before:
Three non-spousal, IRA beneficiaries walk into a bar. Over a round of Shirley Temple hi-balls, AJ, Bob and Chad compare notes on how differently they handled the inheritance of their parent’s IRA.
Chad’s father didn’t name a beneficiary on his IRA, or perhaps he did and the fund company inadvertently lost the form. Regardless, Chad couldn’t claim the IRA directly and the funds defaulted to his father’s estate. Fortunately, Chad was the sole heir and he did end up inheriting the account.
Unfortunately because of this snafu, he couldn’t take advantage of an inherited ‘stretch’ IRA strategy. The IRS only allows this often-preferred option to a named, non-spousal beneficiary – with the beneficiary form firmly in hand. Chad was allowed to do the next best thing: withdraw the inherited money as he chose, but only within the five year period prescribed by the IRS. Chad has to pay taxes on his withdrawals, but at least he can plan ahead with his tax advisor and withdraw these funds when the timing is right.
Bob was a named beneficiary! But he did nothing with his inherited account. He didn’t transfer the funds into an account in his name. He didn’t develop a distribution strategy. Bob just let the money sit. About five years later, he received a letter from the plan administrator. The tax code’s five-year time limit to transfer the money had run out. If he didn’t withdraw everything from the IRA by the year’s end, a fully taxable check for the entire balance would be issued in Bob’s name whether he needed the money or not.
Bob sold an investment property this year. So, by being forced to withdraw the entirety of the inherited IRA in the same year that he’s reporting significant capital gains will send him into an elevated tax bracket. Bob is so distressed just talking about this that he orders another Shirley Temple. A double this time!
AJ, rather sheepishly, shared that his mother informed him in advance that he was the named beneficiary on her IRA. She brought AJ in to speak with her financial planner to explain the benefits of a ‘stretched’ inherited IRA. By directly transferring the account to a properly titled Beneficiary IRA in the year of her passing, he was able to recalculate the Required Minimum Distribution based on his own life expectancy. The five year withdrawal window that Chad and Bob were subjected to didn’t apply to him. This greatly reduced the annual taxable amount he had to withdraw each year, allowing the balance to grow, tax deferred, over the remainder of his lifetime.
In order to avoid a barroom brawl, Al bought the boys another round.
This story is no joke and there is no pithy punchline. A moral, perhaps, can be found here: inheritance errors can be taxing. For everyone involved, hopefully a lesson was learned.