Wednesday, December 12, 2012

Dividing An Inherited IRA



We had a situation where a father left his IRA to his two children. The father was in his 70s, the son was in his 50s and the daughter in her 40s. The tax problem was triggered by having one IRA with two beneficiaries.

There are certain tax no-no's involving an IRA. One is to have your IRA go to your estate. An estate has no “actuarial life expectancy,” as only individuals can have life expectancies. Tax rules require an estate IRA to pay-out much sooner than may be desired or tax-advantageous. A second no-no is what the above father had done.

When there are multiple beneficiaries of an IRA, the IRS requires the IRA to calculate the minimum required distributions (MRD) based on the life of the oldest beneficiary. In our case, it wasn’t too bad, as the siblings were within 10 years of each other. Consider an alternate situation: a son/daughter and a grandchild. In that case the grandchild would be receiving MRDs based on the son/daughter’s life expectancy, which likely would not be in the grandchild’s best financial interest. 

What to do? Split the IRA into two: one for the son and another for the daughter. As long as this is done no later than the last day of the year following the year of death, the IRS will respect the division. This allows the son to use his life expectancy for his withdrawals, and the daughter to use her life expectancy.

 

The jargon for this is “subaccount,” and if you are in this situation (death in 2011), please consider dividing the inherited IRA into subaccounts by December 31.

By the way, there is a tax trap in setting up the subaccounts. These are inherited accounts, and the IRS requires inherited accounts to retain the name of the decedent. What do I mean? Say that Adam Jones passed way, so we would be looking at the “IRA FBO Adam Jones.” When the subaccounts are created, they should be named (something like) “IRA FBO Adam Jones Deceased FBO Benjamin Jones Inherited.” If one does not do this correctly, the IRS can (as has before) consider Benjamin as having withdrawn ALL the inherited IRA and put it into his own separate IRA. Since he withdrew all the inherited IRA, he has to pay tax on all of it, not just the minimum required distribution.

I consider the above tax trap to be unfair, but the IRS has brought down the hammer before. Do not be one of the unfortunate caught in this trap. We have discussed before that even an average person may need a tax pro here and there throughout life. This is one of those moments.

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