When most people set up a retirement account or begin contributing to an employer-sponsored retirement plan, they plan on spending all of the money themselves. After all, they figure, it'll probably never amount to a whole lot, especially if they only contribute $100 every month, with a $100 match from their employer. Then, after 30 years, they wake up to find that they have $300,000 in their retirement account -- well within the realm of possibility with a total return assumption of just 8%.
After retirement, these folks then look at their overall financial situation. Because distributions from IRAs and retirement plans are taxed as ordinary income, many retired people choose to use other assets for their basic living expenses. Even once the IRS starts requiring them to take minimum required distributions from their IRAs and retirement plans at age 70 1/2, they choose to keep as much as possible within their retirement accounts in order to minimize the tax impact.
It is a combination of these factors, along with the above-average investment returns of the 1980s and 1990s, that has propelled the amount of assets in IRAs and qualified plans to extraordinary heights. The Investment Company Institute estimates that total retirement assets reached $14.5 trillion in 2005. With all of these assets locked up in retirement accounts, substantial amounts of money will likely remain for spouses and members of future generations.
As a named beneficiary of an IRA or retirement plan, you need to make sure you follow the correct steps in establishing yourself as the new account owner after the death of the original owner. This article discusses things you should keep in mind as you consider your options.
Spouses as beneficiaries
In most situations involving married couples, people generally name their spouse as primary beneficiary of an IRA or retirement plan. Most people wish to ensure that they provide for their spouse after death. By naming his or her as the primary beneficiary, the spouse will have full access to IRA and retirement plan funds as needed.
The rules for spouse beneficiaries who inherit IRAs or retirement plan accounts are relatively simple. A spouse may take an IRA or retirement plan account assets and move them into an IRA in the spouse's own name. This action, commonly referred to as a spousal rollover, allows the spouse to treat inherited assets as his or her own and to commingle those assets with IRA assets that the spouse has previously saved separately. Once the spousal rollover is complete, all IRA assets are treated identically. For purposes of determining any required minimum distributions, the spouse's age is used to determine the appropriate amount that the spouse must withdraw.
Usually, the spousal rollover option gives the spouse the most flexibility in determining the timing and amount of any desired distributions from retirement assets. By allowing the spouse to consolidate the retirement funds of both spouses into one, substantial reductions in paperwork and tracking often result. If, however, the spouse prefers not to do this, the other options listed below for beneficiaries other than spouses are also available.
Beneficiaries other than spouses have more limited options. Specifically, other beneficiaries are not allowed to take the deceased person's IRA or retirement plan and roll it over into their own IRA account. Instead, they must contact the financial institution that manages the IRA or retirement plan and set up a new account that specifically refers to the fact that the assets have been inherited. For instance, if Jim Smith is John Smith's son and is the beneficiary of John's IRA, the inherited IRA might be titled as follows: "Jim Smith, beneficiary of the John Smith IRA."
Once this account is established, tax rules require that taxable distributions from the inherited IRA must begin within a certain amount of time. The beneficiary has two primary options. First, the beneficiary may choose to take out the entire account balance by the end of the fifth year following the death of the original account owner. If the beneficiary chooses this option, then no distributions are required before the end of the fifth year.
Another option applies to beneficiaries who qualify as designated beneficiaries under tax law. In most circumstances, if the original account owner specifically names the beneficiary on the beneficiary designation form, the beneficiary will qualify as a designated beneficiary. Designated beneficiaries can elect to take minimum distributions over the course of their lifetime. The amount of the required distribution is determined by referring to an IRS life expectancy table. By using this method, beneficiaries can greatly extend the period over which they must take distributions, which may result in deferred taxation and a greater ability to incorporate the inherited IRA into their overall tax planning.
Beneficiaries who wish to take distributions over their lifetimes must make sure that they take the first required distribution by the end of the year following the death of the original account owner. While this may seem like a lot of time, keep in mind that in some complicated estates, a beneficiary may not even find out about a retirement plan account until much of the estate administration has been completed. While the five-year rule is always available, it may lead to a less desirable result from a tax perspective.
A recent change in the law made designated beneficiary status a possibility not only for IRA beneficiaries but also for beneficiaries of qualified retirement plan accounts. Prior to the law change, qualified plan beneficiaries often had to resort to the five-year rule.
These guidelines only define the minimum that a beneficiary must withdraw from the account. The beneficiary always has the right to take more than the minimum required. Furthermore, withdrawals from inherited IRAs are not subject to the 10% penalty even if the beneficiary is less than 59 1/2.
Because financial institutions are not always familiar with how to set up inherited IRAs, you should keep an eye on the process to make sure it is done correctly. By knowing the rules yourself, you can ensure that you will be able to make the most of your inheritance.
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