Posted by , Denise Kovach, CFP®, AIF®
Inherited IRA’s, also known as stretch IRAs, are specifically designed for retirement plan non-spouse beneficiaries – those who have inherited an IRA or workplace retirement plan such as a 401k (although one would be appropriate for a spouse who is under the age of 59-1/2 and needs access to funds). If they are not set up and funded correctly, there could be irreversible and costly consequences.
Here are the most common non-spouse IRA beneficiary errors:
- Disallowed Contributions – Contributions cannot be made to inherited Once a contribution is made, the account is no longer treated as an inherited IRA and becomes taxable. Imagine if you accidentally made a contribution to a $500,000 inherited IRA. The entire $500,000 must be distributed and is taxable!
- Incorrect account titling – Inherited IRAs must be set up with the deceased’s name in the account title. For example: “John Doe (deceased 02/01/2017) IRA, FBO Jane Doe, beneficiary. While some financial institutions do not do this because they record the information in their internal records, this could cause confusion if only the beneficiary’s name is on the account. The reason is because the beneficiary may treat it as his/her own which would nullify the inherited IRA and result in the account being distributed and
- Ineligible rollovers – A non-spouse beneficiary can only do a direct transfer to a properly titled inherited IRA, meaning trustee-to-trustee transfer. If a non-spouse beneficiary tries to do a 60 day rollover where the funds are withdrawn and returned to another IRA within a 60 day period, all of the funds are considered withdrawn and are
- Delaying Required Mandatory Distributions – RMD’s on an inherited IRA must begin by 12/31 in the year after death. Some people confuse this rule with that of being age 70-1/2 to begin RMDs… which is true for IRA owners, not
- Stretch IRA Confusion – Only designated beneficiaries qualify for a stretch IRA. A beneficiary must either be named on the beneficiary form or in a qualified “see-through” trust if the trust is named the beneficiary. If beneficiaries inherit through the estate, they are not designated beneficiaries and cannot stretch the IRA. Instead, the RMD will depend on when the IRA owner died. If the IRA owner died before his RMD date (by April 1 of the year after attaining age 70-1/2), the entire inherited IRA would have to be paid out by the end of the fifth year after the year of death. If the IRA owner died on or after the RMD date, then the beneficiary can take RMDs based on the IRA owner’s remaining single life
- Neglecting timely transfer – The funds must be transferred into a properly titled account before the end of the year following the year of the deceased owner’s death. Otherwise, the stretch IRA option is lost and the funds will have to be paid out via the five year
- Failing to take the deceased owner’s RMD for year of death – if the IRA owner dies after his/her RMD date, an RMD must be taken for the year of the decedent’s death. It cannot be included in a transfer to an inherited IRA. If it is, it must be caught quickly and resolved or it could negate the stretch altogether, causing big tax
This is simply a sampling of some of the more common sorts of mistakes that people make when attempting to stretch an IRA. If it is done correctly, your inherited IRA could turn into a sizeable amount in your lifetime. Proper setup is critical, so get a professional to help you!
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