It’s easier to put money into an IRA than take it out.
Financial advisers have helped clients accumulate a whopping $3.67 trillion in individual retirement accounts. But when it comes to IRA distributions — especially from inherited IRAs — most advisers flunk the basics.
“Moms and dads spend 30 or 40 years building an account, said Ed Slott, a Rockville Centre, New York-based IRA expert. “The average adviser wipes it out in 15 seconds.”
The IRA distribution rules are complex. OK, let’s be honest — they’re mind-numbing. But you ignore them at your peril. Emptying an account the wrong way can trigger taxes and penalties — not to mention lawsuits, errors-and-omissions claims and out-of-court settlements.
Here’s a typical example.
Your client inherited a large IRA from his mother two months ago. He wants to transfer the account from her bank to your firm. But his tax accountant said he must first take a 2007 IRA distribution. The accountant said he should use the
Internal Revenue Service Uniform Lifetime Table to calculate the amount of the distribution, basing the calculation on his mother’s age in the year of her death.
The client is not sure that’s good advice. He told you that his mother took her 2007 required distribution a few weeks before she died. So why would he have to take it again? Besides, if he has to take a distribution from the inherited IRA, shouldn’t it be based on his own life expectancy?
The client is right to worry, according to Mr. Slott. The tax accountant is wrong.
If Mom had not taken her 2007
required minimum distribution, her beneficiary would indeed have to take it for her by Dec. 31 of the year of her death. After a person turns 70½, they must take an IRA distribution every year — and the year of her death is no exception. If she didn’t take it, her heirs must. But your client’s mother did take her distribution, so your client is off the hook.
However, as a beneficiary he does have a deadline for taking his own first distribution from her IRA, which is Dec. 31 of the year after her death — in this case, 2008.
His 2008
required minimum distribution is based on his own life expectancy. To determine the amount, your client should divide the IRA balance on Dec. 31, 2007, by his life expectancy factor. He’ll find that on the IRS Single Life Expectancy Table in the appendix of IRS Publication 590 (the publication can be downloaded at irs.gov). If the client will be 40 years old in 2008, his life expectancy factor is 43.6. His minimum 2008 distribution on a $1 million IRA would be $22,936.
Your client should not use the Uniform Table for Determining Lifetime Distributions. That table is only for IRA owners, not beneficiaries.
This is a crucial distinction. Your client has inherited the IRA, but as far as the IRS is concerned, he doesn’t own it. He’s still just a beneficiary. The difference is that an IRA owner can postpone taxable withdrawals until he’s over 70½. A beneficiary must start taking them almost immediately.
The IRA must continue to be titled in his mother’s name [e.g., Phylis Jones IRA (deceased Feb. 20, 2007) For The Benefit of Robert Jones].
Only a surviving spouse is allowed to roll an inherited IRA into a new IRA in their own name. When any other beneficiary does that, the account immediately becomes taxable, according to Mr. Slott.
This is probably the most common single mistake made with inherited IRAs.
If your 40-year-old client inherited a $1 million IRA from his mother, retitling the IRA in his name would result in a $360,000 tax bill (assuming a 36% tax rate). He’d also owe a $60,000 “excess contribution” penalty for putting $1 million into an IRA. The maximum annual contribution is $4,000.
The biggest cost is four decades of tax-deferred growth. Putting the wrong name on that $1 million inherited IRA has turned it into a $580,000 taxable account.
