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Key Rules for Non-Spouse Beneficiaries

Last Updated August 17, 2017

By: Denise Appleby,CISP, CRC, CRPS, CRSP, APA.

Written for the financial professional

Clients who inherit assets held in a tax deferred retirement account, such as an IRA or 401(k), are eligible for the same tax-deferred treatment on those amounts that were available to the account owners. This means that they will owe income tax only on taxable amounts that they withdraw from the account.

Bear in mind however, that tax-deferral is not indefinite, as these beneficiaries must take required minimum distributions (RMD) from the account.

The RMD amount for a beneficiary is determined by several factors, including age, and the distribution option that applies to the inherited account.

Failure to follow the rules that apply to inherited accounts can result in loss of tax deferred status and IRS assessed penalties.

The following is a high level overview of some of the rules that beneficiaries must follow to help preserve the tax-deferred status of inherited retirement account, and avoid penalties.

Understand Distribution Options

The beneficiary distribution options depend on whether the retirement account owner died before the required beginning date (RBD). Generally, the RBD is April 1 of the year that follows the year in which the retirement account owner reached age 70½.

For example, if a retirement account owner reaches age 70½ in 2016, her RBD is April 1, 2017.

Death before the required beginning date

If the retirement account owner died before the RBD, the beneficiary options are:

·         The five-year rule. Under the five-year rule, distributions are optional until December 31 of the 5th year that follows the year in which the retirement account owner died. By then, the entire balance must be withdrawn from the account.

·         The life expectancy rule. Under the life expectancy rule, the amount that must be withdrawn for a year is based on the beneficiary’s age in that year, and the account value as of December 31 of the previous year.  Life expectancy distributions must begin by December 31 of the year that follows the year in which the retirement account owner died.

A beneficiary can always take more than the RMD amount. The key is not to take less. Because if a beneficiary takes less RMD than he is required to, he will owe the IRS a 50% access accumulation penalty on the RMD shortfall.

For instance, assume that a beneficiary is required to withdraw $10,000 by the end of the year, and he withdraws only $5,000. He will owe the IRS and excess accumulation penalty of $2,500 which is 50% of the $5,000 that he did not withdraw by the deadline.

Caution: It is very important to check the terms of the agreement that governs the inherited retirement account to determine if the beneficiary is subject to the five-year rule or the life expectancy rule. In some cases, the beneficiary might be required to make an election by certain deadlines in order to be subject to the rule that he wants to use.

If you find that your client’s assets are held under a document that includes restrictions to which he does not want to be subjected, he can move the IRA assets to an IRA that is governed by an agreement that suits his objectives. Such movements are subject to deadlines, in order for the rules of the new IRA agreement to apply.

If the retirement account owner died on or after the RBD

If the retirement account owner died on or after the RBD, then the options are to take distributions over the longer of:

·         The beneficiary’s life expectancy, or

·         The remaining life expectancy of the decedent

In either case, distributions must begin by December 31 of the year that follows the year in which the retirement account owner died.

Be careful about moving assets

If you plan to help your client move inherited IRA to another inherited IRA, whether at the same or different financial institution, extreme care must be exercised to ensure that the account is moved properly.

If the wrong method is used to move the account, it could result in loss of tax-deferred status.

A nonspouse beneficiary’s only option for moving an inherited IRA to another is the trustee to trustee transfer method. A nonspouse beneficiary is not eligible to take a distribution and then rollover the amount. That means if a nonspouse beneficiary inadvertently takes a distribution, the tax-deferred status  is lost  and that amount is no longer eligible to be held in an IRA.

Ensure account is properly registered

In addition to meeting certain other requirements, the registration for an inherited IRA must  include the beneficiary’s name and the name of the decedent, clearly showing who is the beneficiary and who is the decedent.

In addition, the account must be registered under the Social Security number of the beneficiary, so that distributions are reported to the beneficiary and included in his income.

Helping your clients

Handling important administrative affairs can seem trivial and unimportant when dealing with the trauma of the death of a loved one. However, delay in handling such affairs can be harmful from a tax and financial planning perspective.

You can help to ensure that the administration of your clients inherited retirement account is as seamless as possible, and done properly  to ensure their desired objectives are met.

As some mistakes cannot be corrected, urge your clients to contact you before they complete any paperwork for any retirement account that they inherit.