IRA Beneficiaries Need to Know Their Options
One of the most overlooked planning items is naming and then reviewing your IRA beneficiary. Your IRA beneficiary will inherit the assets in that IRA. We recommend that IRA owners review and update the beneficiary designation whenever a significant life event occurs (birth, divorce, marriage or death). It is equally important to understand the rules surrounding an inherited IRA, as failure to comply with these rules can result in a costly mistake.
If an IRA owner dies and there are still funds left in the account, the remaining assets in the IRA generally must be distributed based on one of four basic methods:
- A lump sum
- The five-year rule
- The life expectancy rule
- A spousal rollover
The first three options may be used by nonspousal beneficiaries. Spousal beneficiaries may also elect one of the first three options, or, if named as the sole beneficiary of the IRA, they may also opt to roll the assets into an IRA account in their name (or an existing IRA account in their name).
The most straightforward distribution option for any beneficiary- spouse or nonspouse- is to take a lump-sum distribution of the full proceeds after the IRA owner dies. While circumstances may deem this to be a viable option, the beneficiary may face a large and unwanted tax liability as a result, and other options may be more appropriate.
The second distribution option, the five-year rule, allows an IRA beneficiary to take distributions over five years. By electing this option, the entire account balance must be distributed within five years after the owner’s death (December 31 of the year containing the fifth anniversary of the IRA owner’s death). This option is mandatory under certain circumstances, but, if elected, may expedite an unwanted tax liability.
Distributions over life expectancy are a third option, and for most, is the option that makes the most sense. According to the Life Expectancy Rule, a beneficiary can spread distributions over his or her life expectancy after the account owner dies. Distributions, and the associated tax liability, can be minimized using this option. From a tax planning perspective, this is the best option.
Finally, the last option applies to spousal beneficiaries only, provided they are the sole beneficiary. The spousal rollover rule allows the spousal beneficiary to roll over the plan funds into an IRA in their own name. The spouse then becomes the owner of the IRA, and the required distribution rules are based on the spouse’s age and life expectancy.
Please contact your ACM wealth advisor should you have any questions about an inherited IRA, or need advice as to the best distribution strategy to choose.
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