Step One: Stop and Think
You should always avoid making quick decisions when it comes to your finances, but especially if you inherit a retirement account. If you plan with care, you can continue to take advantage of the tax-benefited growth in the account that the owner started. Penalties for making a mistake with a distribution can be steep. So it’s important to watch for four important deadlines: the nine-month anniversary of the account owner’s death, December 31 of the year the account owner died, and October 31 and December 31 of the following year. Keep an eye toward these important dates, and be sure to spend time you need gathering all the information about your options and getting good advice before executing your plan.
Immediate Steps
You need to take six basic steps as soon as possible after a retirement account owner dies. This timeline is mainly driven by the need to make sure you have enough time to complete any required distributions before the end of the year, but it also works as a good first step to organizing the person’s estate.
1. Collect all the financial information you can find. Pay particular attention to the values of the retirement accounts. Eventually, you’ll want a complete list of all accounts, each account’s beneficiaries, the value of the accounts when the person died, the value of the account as of the previous December 31, and whether the account has any basis. The basis is the amount you can withdraw from the account without paying taxes. (See Chapter 3 for more detail.) Other information you need to note related to the retirement accounts is the person’s age when he died, his date of birth, and, if he has one, the date he opened his Roth IRA account.
2. If the person was past age 70½ when he died, his required minimum distribution or RMD needs to be made for the year he died. His account statement or statements will show whether or not he made a distribution. If a distribution must still be made, the executor will need to contact the financial institution. Be sure that an RMD is made from each retirement account or that one RMD is made covering the total of all accounts. You don’t need to worry about RMD in this case if the account was a Roth (see Chapter 3).
3. The primary beneficiary has nine months after the account holder’s death to refuse—or disclaim—the inheritance in order to have the account pass to the contingent beneficiary. If you think this might be a good estate planning option for you, do some financial planning in the short term so you can make a decision and let the executor and the retirement plan trustees know. This option is helpful if the primary beneficiary has her own income and doesn’t need the assets from the IRA; it could be a good tax-saving strategy to pass the inheritance to the contingent beneficiaries.
Nest Eggs
If you’re the executor, you need an estate lawyer to help you. Contact the lawyer who created the will or check with your state bar association for a list of estate lawyers near you. Find your state bar association easily online with a web search of your state’s name and “state bar association.”
4. You have until December 31 of the year after the account holder died—for example, if the account holder died December 12, 2008, you have until December 12, 2009, to start taking your own RMDs based on your life expectancy. You need to start taking these withdrawals even if the account holder was under age 70½ when she died. If there was more than one beneficiary of the retirement account, this is also the deadline for each to set up their own inherited IRA so that RMDs can be calculated on their own life expectancy. If you miss this deadline, you can still set up separate accounts, but the RMD calculation must then be figured on the oldest beneficiary’s life expectancy. Depending on circumstances, this might make your RMD (and the taxes due on the RMD) bigger. Be very careful about how you title your new inherited IRA account (the account trustee will help you). If you title your inherited IRA wrong, you won’t get the chance to stretch your RMDs over your lifetime. More on this next.
5. If a trust is the beneficiary of the account instead of a person, October 31 the year after the account holder died is the deadline for submitting the trust information to the account trustee. The account trustee has to determine whether or not the trust qualifies for favorable RMD treatment.
6. Start collecting the advisors you’ll use to help you make choices about your inheritance. Contact your financial planner, your accountant, and the executor of the estate.
Assess Your Options
Once you’ve organized the basic information about the retirement accounts you’re inheriting, find out what options are available to you as beneficiary. These options could include:
• Withdrawing the balance, making a lump sum distribution of the account right away.
• Taking distributions over five years.
• Taking distributions over your lifetime or at the same pace that the original account owner had already begun taking them.
The retirement plan trustee can answer these questions by referencing the plan document or the employer if the account is a work plan like a 401(k), 403(b), or 457 plan. Once you notify the trustee that the account owner has died, he will usually send a packet of information to the beneficiary (you) with the options you can choose for the account and a list of the documents you’ll need to complete the distribution. These documents are often just simply the death certificate and information on where the money is to be transferred.
Rainy Days
Sixty-day rollovers are not available with retirement account money that you inherit. Only direct trustee-to-trustee transfers can be made without triggering tax on the distribution. If the trustee insists on cutting a check instead of making an electronic transfer, be sure he makes the check out to your retirement account and not to you personally, for example, “Fidelity Investments for the benefit of John Smith.”
Except in the case of the lump sum distribution, you’ll need a new account to receive the money. The trustee will include an account application to encourage you to keep the money with his institution, but you’re not required to. You can choose your own retirement account trustee (see Chapter 3).
Once you know your distribution options, you need to figure out the tax ramifications of your choices before deciding which will work best for you. You’re taxed on withdrawals from the retirement accounts in the same way the original owner would have been, except you won’t owe the extra 10 percent penalty for being under age 59½. And just like making an IRA direct trustee-to-trustee transfer out of your own account, as long as you keep the money in a retirement plan, you keep the tax deferral.
There are three key tax-related things to keep in mind when deciding when and how to manage your inherited retirement account:
• You pay income taxes on the amount of money that you distribute from the retirement account (and don’t transfer to another IRA).
• You don’t pay taxes on the principal of a Roth account, and only pay income taxes on any earnings you distribute if the account isn’t at least five years old.
• If the retirement account has a basis—the amount that was deposited after-tax—you can withdraw that amount tax-free on a pro-rata basis of all your IRA balances. Check the account owner’s tax return for form 8606 to see if there is a basis in the account.
Unless you need the money right away, your goal should be to save taxes by continuing the tax deferral in your own retirement account or what’s called a “beneficiary” or “inherited” IRA for as long as you can.
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