As a financial advisor of 20+ years, one of the hardest things I’ve helped anyone deal with is the loss of a loved one. Far more often than not, we get calls from widows who have no idea what they own, or what to do with it.
Unfortunately, cloudiness leads to confusion. Many surviving spouses become victims of shady brokers masquerading as a financial advisor or planner. The confusion and sadness makes them vulnerable to a good sales pitch. Rather than have a cohesive financial plan created for them, they fall prey to fat commission insurance and investment products.
One of the most common items a spouse must deal with is the decedent’s IRA. When a spouse inherits an IRA, they have a lot of options how to handle it! Knowing which options are most beneficial can make a big difference in the survivors ultimate financial success or failure. Mishandling a spousal beneficiary IRA can lead to taxes, penalties, and loss of future tax-deferred investment growth.
What to do when a spouse inherits an IRA?
#1 Roll the inherited IRA into an IRA in your own name.
A surviving spouse has the most flexibility with an inherited IRA. Spouses are the only beneficiaries who have the option to rollover the IRA into an IRA titled in their own name.
The flexibility to treat the decedent’s IRA as your own gives you ultimate discretion with the IRA. Most importantly, discretion with handling the timing and amounts of IRA distributions.
When a spouse inherits an IRA and rolls it into one in their name, the IRA is 100% theirs for all intents and purposes. This means they treat the IRA as their own, disregarding the fact that it came from another person, distribution requirements and all!
If the decedent was taking required minimum distributions, they must now be calculated and taken based on the surviving spouse’s own age and requirements. As such, they can be deferred until required minimum distributions must be met for the survivor. Those calculations are determined based on your life expectancy according to the Uniform Lifetime Table.
This is a pretty good deal if the surviving spouse doesn’t need the money right away. It allows them to continue their tax-deferred growth (or tax-free in the case of a Roth). But watch out! There are potential consequences if the surviving spouse is under age 59 and 1/2.
For younger surviving spouses (under age 59 and 1/2), treating the IRA as their own subjects them to the potential 10% penalty – in addition to ordinary income tax – on any IRA withdrawals. This can be financially harmful should the surviving spouse need funds prior to reaching that 59 and 1/2 age.
Rather than treat the IRA as their own (rolling it into an IRA in their own name), younger surviving spouses should consider keeping it as an inherited IRA (option #2).
Was the decedent spouse taking RMD’s when they died?
Pay special attention to the decedent’s required minimum distributions if they were age 70 and 1/2 or older. If the decedent was required to take RMD’s, they’re still required to fulfill that RMD for the year they passed.
Check with your deceased spouse’s IRA custodian. Ask them if they fulfilled their required minimum distribution for the year. If they were required to take their RMD in the year they died, you have until December 31st to get that done.
While the required distribution must be completed, it’s important to make sure it’s reported under their Social Security number. If it’s reported under yours, the required distribution will not have been fulfilled.
The penalty for missing an RMD is 50% of the amount. This is a painful and costly penalty, so please pay special attention to fulfilling the required distribution timely in your deceased spouses Social Security number.
#2 Roll the decedent’s IRA into an Inherited IRA for the benefit of the surviving spouse
For a surviving spouse under age 59 and 1/2, keeping the IRA as an inherited IRA for your benefit may make the most sense. If you may need the funds, you’ll only be subject to ordinary income taxes – NOT the 10% early withdrawal penalty!
Keeping the assets in an inherited IRA may lead to additional required distribution complications however. You can:
- Begin taking required minimum distributions in the year after the decedent dies, OR
- Delay RMD’s until your deceased spouse would have been 70 and 1/2 (when the IRA would have been subject to RMD’s anyway).
If you’re older than your deceased spouse was, the required minimum distributions are based on their IRS Single Life Expectancy table. This means the amounts you must withdraw may be less than if you treated the IRA as your own. It’s a very nifty rule which may allow you to stretch the IRA farther!
The IRS 5 year rule
Another piece to this puzzle is the IRS 5 year rule which you may also want to use. If your spouse dies before their required beginning date (when they must take distributions), you can distribute the IRA over your life expectancy OR by December 31st of the 5th year since they died.
Granted, it’s unlikely that the 5 year rule makes much sense for anyone. Pulling large chunks of taxable money out prior to this 5 year deadline can create a nasty financial impact. You not only lose your future tax-deferred growth, but these larger withdrawals may push you into a higher tax bracket.
Roth IRA’s are treated differently
Normal Roth IRA’s currently have NO required minimum distributions. The IRS allows the original account owner to leave Roth IRA funds alone until they die. This is unlike a traditional IRA, and may possibly change in the future.
An Inherited Roth IRA does however impose required minimum distributions on the account holder (spouse or not). If you inherit a Roth IRA, you must start withdrawing funds by December 31 of the year after your spouse died. Distributions are based on the Single Life Expectancy table.
Provided the funds were in the Roth IRA for at least 5 years, these required distributions are completely tax free. If the account was held for less than 5 years, only the growth is subject to ordinary income tax. There are no 10% early distribution penalties imposed upon any Inherited IRA distributions.
While you could invoke the 5 year rule, it would be quite foolish. Roth IRA funds are hard enough to come by. Distributing them in their entirety within 5 years should be an absolute last resort, and only in a financial emergency!
Taking the Inherited IRA option? Be wary the formalities
There are very specific rules for an Inherited IRA. IRA custodians may interpret this differently, but generally:
- The IRA must state “Inherited IRA” in the account title
- The beneficiaries name must be in the account title
- The decedent’s name must be in the account title
So, a proper account registration would be something like “John Jones Inherited IRA FBO Jason Jones”. Paying attention to the details can save you heartache later!
#3 Roll to an IRA and convert to Roth
Assuming the IRA in question is a traditional IRA (not a Roth IRA), you may want to roll it into an IRA in your name. After doing this, provided the tax consequences are appropriate for your situation, convert that into a Roth IRA.
Keep in mind, there are some really cool things you can do with Roth conversions. First, you can really emphasize Roth asset location in your financial plan. This can supercharge your tax free Roth IRA! The Roth IRA is completely tax free after all, why not allocate your highest potential growth assets to it?
Second, you can do strategic Roth recharacterizations. If you plan wisely and take advantage of current tax law, you can further juice up your Roth IRA by watching potential recharacterization opportunities. Why pay more in taxes when it’s unneccessary?
#4 Don’t accept the IRA
Probably the most rare of the options is to disclaim the IRA altogether. If you’ve got plenty of money, there may be no point in you accepting the IRA in the first place.
If you disclaim the IRA, it will automatically transfer to the contingent beneficiaries. These may be your kids who can use the funds. It may even be a trust or a charity. Regardless, the IRA skips to the next available beneficiaries.
Contingent beneficiaries are typically younger. While they’re required to take IRA distributions over their lifetime, the ratio of how much they’re required to withdraw forces smaller distribution amounts.
Typically, the only IRA owners who would use this strategy are those with very large estates. If you have an estate which exceeds the tax exemption amount, this is potentially a great option for you!
You must decide if you’re going to disclaim the IRA within 9 months of the original IRA owners death. You can’t change your mind either! So if there’s any doubt at all, you should consider one of the first two options mentioned above.