IRAs that have passed to a beneficiary following the IRA owner’s death have various rules depending on the beneficiary’s relationship to the IRA owner. An IRA acquired by a beneficiary on the death of someone other than a spouse is an “inherited IRA.”
A distribution from an inherited IRA may not be rolled over tax-free. The non-spouse beneficiary of an inherited IRA cannot treat the inherited IRA as his own. The beneficiary cannot:
- Make contributions to the IRA (i.e., deductible contributions are not allowed), or
- Roll over amounts into or from the inherited IRA.
However, the beneficiary is allowed to make a trustee-to-trustee transfer (also referred to as a “direct rollover”), as long as the IRA where the amounts are being transferred is set up and maintained in the name of the deceased IRA owner “for the benefit of the beneficiary.”
Example: Four sisters who were beneficiaries of their mother’s IRA created four equal subaccounts in the mother’s name and each with one as beneficiary. The IRS privately ruled that a direct trustee-to-trustee transfer of the IRA after the mother’s death, as opposed to a rollover of an IRA, did not affect the tax deferred status of the IRA. Even though the IRA fit the description of an inherited IRA, the IRS said there is no prohibition against a non-spousal beneficiary having the IRA moved from one trustee (or custodian) to another. The mere segregation into subaccounts of the interests of multiple beneficiaries to an IRA by the trustee/custodian of the IRA, at the request of the beneficiaries, does not affect the character or qualifications of the trustee or of the IRA. Furthermore, the act of segregation of multiple interests in an IRA trust does not render any beneficiary’s interest in the IRA forfeitable and subject the beneficiary to any tax consequences in and of itself. Thus, the transfer was not treated as a taxable distribution to the sisters.
If a designated beneficiary of an inherited IRA received a distribution from the IRA and then rolled over the distribution into two new IRAs, they would have to include the distribution in taxable income. These transactions did not constitute trustee-to-trustee transfers. Even though the financial institutions involved promised to recast the transactions as trustee-to-trustee transfers, the IRS said the mistakes could not be undone.
This failed trustee-to-trustee transfer illustrates the importance of tax planning for inherited IRAs. A properly executed transfer would have avoided current tax on the full amount of the inherited IRA and could have kept the IRA’s tax shelter alive for many years.
Required Minimum Distributions
Required Minimum Distributions (RMDs) must be taken on inherited IRAs as follows:
- If the IRA owner dies before her required beginning date, then RMDs must be either:
- Made over the beneficiary’s life expectancy, but only if distributions begin on or before Dec. 31 of the year following the year in which the IRA owner died; or
- Entirely distributed by Dec. 31 of the fifth year following the IRA owner’s death.
- If the IRA owner dies after her required beginning date, then RMDs must be made over the beneficiary’s remaining life expectancy or, if longer, the IRA owner’s remaining life expectancy.
Proper tax planning and consulting with regard to inherited IRAs can save hundreds or thousands of dollars in taxes. For more information on this topic or any other tax-related issue, please contact Henssler Financial at 770-429-9166 or [email protected].