THE BENEFICIARY’S OPTIONS UNDER THE FINAL RULES ISSUED APRIL 16, 2002. THESE RULES REMAIN VALID AS OF JANUARY 2016.
Initially, it is important to realize that IRA accounts are similar to life insurance policies in that you do get to designate a beneficiary to receive the money upon your death. If you fail to name a beneficiary, or if the beneficiary you have named fails to survive you and you haven’t named a contingent beneficiary, then the terms of the IRA account will dictate the recipient of the money. As such, you should review your beneficiary designations from time to time to make sure they meet with your current objectives.
The rules with respect to inherited IRAs are some of the most complicated in the tax code. Until April 2002, we have been operating with proposed rules that were first issued in 1987 and revised in January 2001. The January 2001 proposed rules did simplify certain issues. However, it wasn’t clear if those rules applied if the IRA owner died before the year 2000. The IRS eliminated that confusion when it issued final rules on April 16, 2002. Starting with 2002 distributions, all IRA beneficiaries can rely on the final 2002 rules regardless of when the IRA owner died. In 2002, taxpayers can also rely on either the 1987 or the January 2001 rules. However, since the 2002 final rules include a new life expectancy table, almost all taxpayers will get a break by relying on the new rules. This article only covers the new rules.
While much of this is confusing, there is at least one simple rule. That is, the full amount of any IRA distribution to a beneficiary will be subject to federal income tax; just as it would have been had the original owner received the distribution. This, of course, assumes that all of the contributions to the IRA were deductible contributions. The complicated part is “When must the beneficiary draw the money from the IRA?”
THE GENERAL RULES
As a general rule, after the IRA owner dies, the beneficiary can withdraw the moneys over his or her remaining life expectancy. The beneficiary’s remaining life expectancy is calculated using the age of the beneficiary in the year following the year of the IRA owner’s death, reduced by one for each subsequent year. The IRS has tables for making these calculations. The single life table can be found here.The beneficiary must take the first distribution no later than December 31 of the year following the year of death. Even though this sounds straightforward, the rules are tricky. For example, if you name your estate as your beneficiary, that will not qualify as a “designated beneficiary” for purposes of this rule. Also, if you name your three children as beneficiaries, they may be stuck with taking withdrawals based on the life expectancy of the oldest child.
There are special rules where the IRA owner failed to name a designated beneficiary. In this case, the rules differ depending upon whether the IRA owner died before or after his “required beginning date.” The “required beginning date” (the RBD) is April 1 of the year following the year in which the IRA owner reaches age 70½. If you die after the RBD and have no designated beneficiary, then the distribution period is the IRA owner’s life expectancy calculated in the year of death, reduced by one for each subsequent year. If the IRA owner dies before the RBD and there is no designated beneficiary, then the IRA must be distributed within 5 years after death. In all cases, whether there is a “designated beneficiary” must be determined by September 30 of the year after the IRA owner’s death, and not as of the December 31 as was the case under the January 2001 proposed rules.
SPECIAL RULES FOR THE SPOUSE
There is one major exception to these rules. It applies where the IRA owner’s sole beneficiary is a surviving spouse. The spouse has a couple of options that are not available to any other beneficiary. One option is that the surviving spouse can take withdrawals over his or her life expectancy, and the withdrawals must start no later than the date on which the deceased IRA owner would have been age 70 ½. Another option is available if your spouse is named as your IRA beneficiary. That is, the spouse can elect to treat the IRA as being his or her own. In essence, this amounts to an IRA rollover. A surviving spouse is the only beneficiary who has this rollover option. With the “rollover” option, the surviving spouse doesn’t have to start distributions until he or she reaches age 70½. Therefore, if your spouse is the beneficiary, they may be able to wait to begin withdrawals, whereas a child or any other person would generally want to begin taking moneys before the end of the year following the year of your death.
As you can see, the tax rules in this area are quite complex. Moreover, this is only a general explanation of the federal income tax rules and doesn’t consider the possible inheritance or estate taxes on IRAs. As such, as is the case with most tax and legal matters, individual facts or circumstances may alter the application of the above rules or may involve other legal and tax considerations not mentioned here. In situations like these, you should seek professional advice tailored to your individual circumstances.