Inherited IRAs: planning tips for non-spouse beneficiaries of IRAs, 401s

California CPA, March-April, 2004 by Joyce L. Franklin

A young woman came to me recently looking for help in sorting out her investments after her mother's death. Her mother was diagnosed with a terminal illness in 2000 and died in 2002. Unfortunately, the mother's overall financial planning was inadequate and resulted in major restrictions faced by her heirs.

The rules in this article relate only to IRAs and retirement plans inherited by non-spouse beneficiaries; spousal beneficiaries are subject to different rules.

The Starting Point

My client and her sister each inherited 50 percent of three retirement accounts: a traditional IRA, a Roth IRA and a company-sponsored 401(k). The mother was not married at the time of her death.

The default rule for withdrawal from these plans by non-spouse beneficiaries is to begin minimum required distributions by Dec. 31, 2003, the year after the account owner's death. The alternative is to withdraw the balance of the account's assets within five years of the date of death.

For each option, income tax (but no penalty) will be due on the amount withdrawn from the IRA and 401(k) accounts. Roth IRA distributions are subject to special rules, which are detailed below.

We split each of the retirement accounts into two more accounts with the prior custodian, effectively transferring the ownership to my client and her sister. My client complied with the minimum required distribution rules and took the first distribution from her inherited retirement plans in 2003. She will continue to stretch out the retirement plans over her lifetime until the accounts are exhausted.

Calculating IRA Minimum Required Distributions

The beginning MRD for each retirement account is determined by the non-spouse beneficiary's age in the year after the account owner's death. In this case, we divided the Dec. 31. 2002 balance in the IRA by 51.4, the factor for a 32-year-old from the Single Life Table [Section 1.401(a)(9)-9, A-1].

My client's 50 percent share of the IRA balance was $160,000 on Dec. 31, 2002, therefore her first year distribution in 2003 was $3,171.21. Each subsequent year, the MRD will be determined by taking the prior year Dec. 31 account balance and multiplying it by the factor for her age in the distribution year.

Distributions from the traditional IRA will be taxable at my client's marginal tax rate. Any after-tax IRA contributions must be allocated proportionately to each distribution and will avoid tax.

Generally, the best time to take distributions from an IRA is late in the year to maximize the deferral. But be careful--if distributions are requested too close to Dec. 31, the custodian may not have time to process your request before the end of the year.

The Five-Year Rule for Roth IRAs

There are no minimum distribution requirements on your own Roth IRA. However, a beneficiary must take distributions from an inherited Roth IRA in one of two ways: over the beneficiary's life, allowing the majority of the account to stay intact and grow tax-free, or within five years of the account owner's death.

Since Roth IRA contributions are not tax deductible, qualified distributions from a Roth IRA will be tax-free. Any funds that remain in the Roth IRA grow tax-free and there will be no tax on "qualified" withdrawals from the account.

Roth IRA distributions are taxed differently than traditional IRA distributions and understanding this rule can save your clients significant dollars.

Distributions from a Roth IRA are income tax free if they are "qualified," which is defined as distributions five years after the contribution was made.

For example, my client's mom funded her Roth IRA only once, with a contribution in 1999. Withdrawals from this Roth IRA are qualified under the five-year rule if they are made on or after Jan. 1, 2004. The time between the contribution date and the qualified withdrawal date is known as the five-year period.

If a distribution is made from a Roth IRA prior to this five-year period, it is a nonqualified distribution. The ordering rules determining the taxability of nonqualified Roth IRA distributions include:

1. Participant "regular" contributions are not taxable;

2. Participant rollover "conversion" contributions are not taxable; and

3. Earnings on contributions (either regular or conversion) withdrawn during the five-year period are taxable at the beneficiary's marginal tax bracket.

To summarize, Roth IRA withdrawals during the five-year period avoid tax as long as they are from contributions. After the five-year period, all Roth IRA distributions are tax-free to the beneficiary.

Planning for an Inherited 401(k)

A mistake my client's mother made before her death was not rolling her 401(k) into an IRA. The 401(k) plan document controls whether or not a non-spouse beneficiary will be allowed to stretch out a retirement plan, and it also controls how the funds will be invested if they are to stay in the plan.

In my client's case, the plan document specified that non-spouse beneficiaries are allowed to stretch out the 401(k), but that assets must be kept in the plan, limited by the investment elections available to company employees.