Kathy, a 42-year old, inherits a $500,000 individual retirement account (IRA) from her 68-year old father. Her insurance agent tells her she must empty it by the end of the fifth year after her Dad’s death.

On December 31, of year five, she cashes out the IRA, now worth $700,000. The result is that she pays $325,510 in income taxes and loses a 40.6-year tax deferral worth thousands in tax savings.

The alternative, since Dad died before he turned 70 1/2, is to take the money over five years of her life expectancy.

Sounds pretty technical, but with literally billions of dollars stashed away in IRA accounts, the tax consequences for beneficiaries is enormous. Most IRA account holders are still living, but in the next 5 years, hundreds of thousands will die leaving their beneficiaries a tax headache.

I recently read a wonderful article in the inaugural, issue of Bloomberg Wealth Manager entitled “The IRA Minefield” where the author, Lynn Breener summarized 10 of the most common errors with IRA distributions. I will cover 5 of them this week.

1. Forgetting that estate taxes on the decedent’s IRA are deductible from the beneficiary’s income taxes. Each beneficiary receives a full income tax deduction for the amount of estate taxes paid on the value of the IRA account included in the estate of the deceased account owner. In every estate where there is a potential estate tax bill, each beneficiary needs to be notified that the estate taxes paid on the IRA value are deductible against the inherited value of the IRA and therefore less income tax are due on the IRA.

2. Retitling an IRA without considering the consequences. A surviving widow may legally roll the deceased spouse’s IRA account into an IRA in her name.
However, if she is under age 59 1/2, any future withdrawals are subject to the 10 percent early withdrawal penalty plus regular taxes. It could make sense to leave the IRA in the name of the deceased spouse and have the widow withdraw as beneficiary. This eliminates the 10 percent penalty.

Non-spouses cannot legally roll inherited IRAs into their own names. If this is done by mistake, the entire IRA becomes taxable to the beneficiaries.
According to Ed Slott, editor of Ed Slott’s IRA advisor, “If John Smith is the decedent and his four kids are beneficiaries, four accounts should be titled, John Smith IRA, deceased, for the benefit of ‘each child.’” Slott added, “The date of death should appear next to the word deceased, and the kid’s Social Security numbers also should be on the new accounts. If the beneficiary is a trust, the account should be retitled ‘John Smith IRA deceased, for the benefit of the Mary Smith Trust.’”

This will allow the beneficiary to withdraw the funds without the 10 percent penalty tax.

3. Selecting -or defaulting to-the wrong IRA distribution method.
When an IRA owner dies before April 1 of the calendar year after he or she turns 70 1/2, the owner’s beneficiaries other than a spouse have two choices: they can empty the IRA within five years or take distributions over their life expectancies.
Taking it over the life expectancy appears to be the best choice since you can always take more than the annual minimum if you need it.

Many beneficiaries who are not spouse often take the IRA proceeds faster than they have to. Why? When an IRA owner names a beneficiary who is not a spouse, that beneficiary is assumed to be at most 10 year younger then the IRA owner, for the purpose of calculating their joint life expectancy. The 10 year rule applies only while the IRA owner is alive.

An example may help. If 70 year old Dad names his 40 year old daughter as beneficiary, their true joint-life-expectancy is 42.9 years.
However, during Dad’s lifetime, he must apply the 10-year rule and it cuts their joint life expectancy to 26.2 years. If Dad dies at age 80, his daughter can revert to the actual 42.9-year life expectancy determined when Dad was 70 1/2, subtract the 10 years that have elapsed and she takes distributions over the remaining 32 years. Her tax liability is much more gradual.

4. Rolling money from a qualified retirement plan into an IRA without first getting notarized spousal consent. Retirement plans with more than $5,000 require a notarized spousal consent to roll the money into an IRA. Without the waiver, the distribution is illegal and therefore it’s taxable.

It’s not a big deal unless an IRS audit occurs.
However, if a divorce or separation has transpired since the rollover, it may be hard to get an ex-spouse to sign a waiver after the fact. Also, pre-nuptial agreements cover spouses-to-be, not spouses. Only a spouse can waive the IRA rights.
5. Failing to name a beneficiary. In most cases, this means the estate automatically becomes the beneficiary. Since the estate does not have a “life expectancy,” the entire IRA becomes subject to income taxes when its owner dies.

However, if the spouse is the sole beneficiary of the estate, the IRS has given private letter rulings, allowing the decedent’s IRA to be rolled into a spousal IRA. If the size of the IRA is substantial, requesting a private letter ruling may be worth it.

This is a rather technical area of retirement and tax planning, but since the magnitude of the IRA dollars is so large, it is essential that careful planning be used.
Notable Quote: “During the first period of a man’s life, the greatest danger is: not to take the risk.”
-Soren Kierkegaard