Inheriting an IRA without messing up your required minimum distributions (RMDs) is surprisingly difficult. There are thousands of articles telling you things not to do that even estate attorneys can make mistakes. The worst part is many of these articles have seeming disagreements. One says that you should never leave your IRA to a trust. Another touts the benefits of establishing an IRA Beneficiary Trust. All this advice is very confusing to sift through.
To provide clarity, we need to examine the source from which all these differing articles flow: the Congressional law governing inherited RMDs.
I was surprised to discover that the rules regarding inherited IRA RMDs are found in the “Qualified pension, profit-sharing, and stock bonus plans” section. In other words, the rules that govern what makes your employer’s 401(k) plan a qualified retirement plan is the same law that establishes inherited IRA RMD rules. The code is “26 U.S. Code § 401” — that’s the 401 of a 401(k) plan.
The section that pertains to the RMDs of inherited IRAs is 401(a)(9) called “Required distributions.” The section begins:
(A) In general.—A trust shall not constitute a qualified trust under this subsection unless the plan provides that the entire interest of each employee—
(i) will be distributed to such employee not later than the required beginning date, or
(ii) will be distributed, beginning not later than the required beginning date, in accordance with regulations, over the life of such employee or over the lives of such employee and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee or the life expectancy of such employee and a designated beneficiary).
In other words:
- The custodian must distribute the RMD to the IRA owner. (They can’t refuse to distribute or hold it somewhere in the plan.)
- The RMD must be calculated off the life expectancy of the IRA owner or his/her immediate designated beneficiary according to standard RMD rules.
- The RMD cannot be recalculated based on the life expectancy of a second generation heir.
These are basic RMD rules as we already know them. Then, Section 401(a)(B)(ii) reads:
A trust shall not constitute a qualified trust under this section unless the plan provides that, if an employee dies before the distribution of the employee’s interest has begun in accordance with subparagraph (A)(ii), the entire interest of the employee will be distributed within 5 years after the death of such employee.
Translated that means:
- If an IRA owner dies before turning 70 1/2 years old, then the balance of the IRA must be distributed within 5 years of his or her death.
This is the infamous “5-Year Rule” of RMDs that everyone fears so much. And for good reason. If 1.6 times a withdrawal rate from your Roth IRA can make $1.1M difference, can you imagine what a difference taking 10 times that amount would do?!
Now you’ll notice that this 5-Year Rule applies to any IRA where the decedent died before the year they would or did turn 70 1/2 years old. This is initially terrifying — Are we all taking inherited RMDs wrong? Why did no one mention this?! -- and then we read 401(a)(9)(B)(iii):
(iii) Exception to 5-year rule for certain amounts payable over life of beneficiary.
Whew. But this is interesting. For IRA-owning decedents, the 5-Year Rule is the rule. All other inherited RMD rules are just exceptions. That’s why everyone is so scared. To stretch the IRA, which is so beneficial, you need to fit in one of these exceptions! Here they are:
(I) any portion of the employee’s interest is payable to (or for the benefit of) a designated beneficiary,
(II) such portion will be distributed (in accordance with regulations) over the life of such designated beneficiary (or over a period not extending beyond the life expectancy of such beneficiary), and
(III) such distributions begin not later than 1 year after the date of the employee’s death or such later date as the Secretary may by regulations prescribe,
for purposes of clause (ii), the portion referred to in subclause (I) shall be treated as distributed on the date on which such distributions begin.
- The RMD should be either distributed outright to the beneficiary or, if held in a trust for the beneficiary’s benefit, have a portion distributed out of the trust to the beneficiary.
- The RMD should calculated using standard elsewhere-defined life expectancy rules.
- These RMDs should start in the year after the previous IRA owner’s death.
(iv)Special rule for surviving spouse of employee.—If the designated beneficiary referred to in clause (iii)(I) is the surviving spouse of the employee—
(I) the date on which the distributions are required to begin under clause (iii)(III) shall not be earlier than the date on which the employee would have attained age 70½, and
(II) if the surviving spouse dies before the distributions to such spouse begin, this subparagraph shall be applied as if the surviving spouse were the employee.
- Spouses are allowed to treat the IRA as though it were their own, taking RMDs normally at and after age 70 1/2 years old.
So far this is all things we know:
- Spouse beneficiaries can do Spousal Rollovers.
- Non-spouse beneficiaries use the Single Life Table to calculate their Inherited RMD.
- If the assets are in trust, there needs to be a clear beneficiary who receives distributions of any size from the trust to qualify as a “Look-Through Trust.”
Here’s the kicker though, 401(a)(9)(E):
For purposes of this paragraph, the term “designated beneficiary” means any individual designated as a beneficiary by the employee.
At first thought this is a “Duh!” moment: designated beneficiaries are designated by the owner as beneficiaries. Then, this innocent tautological definition causes all sorts of ramifications.
Imagine that an IRA doesn’t have any designated beneficiaries. In this scenario, the IRA goes to probate, as all assets without “will substitutes” do, and is divided according to the decedent’s will — to the children, let’s say. Problem is, those children were not designated beneficiaries so they don’t qualify for one of the two exceptions (a designated beneficiary or a spouse). Thus, they are subject to the 5-Year Distribution Rule. If probate passes the IRA to a spouse, well, he or she always has an exception to do a Spousal Rollover. If probate passes it to a trust, it doesn’t matter how the trust is set up, it was not designated as a beneficiary, so it uses the 5-Year Rule.
Now, people or trusts can qualify for the exception by being designated as beneficiaries. In fact, in a Private Letter Ruling, the IRS set the precedent that even probate and the successive heirs named there can qualify for an exception if your estate was designated as a beneficiary.
This is the power and importance of beneficiary designations and why it is so important to set them.
Photo used here under Flickr Creative Commons.