Lynn Brenner's Family Finance

Inherited Roth IRA: What Are the Rules for Beneficiaries?

Q: I know that I never have to take distributions from my Roth IRA. There's no mandatory payout age. But I've heard that the rules are different for a Roth IRA beneficiary. Is that true? My daughter is my beneficiary and I want to leave a note attached to my will, telling her how she has to handle the Roth IRA. -- BD via email

 

A: That's a very good idea. You're right – the distribution rules are different for beneficiaries.

As you say, a Roth IRA owner never has to take any withdrawals from the account. This is one of the ways a Roth is different from a traditional IRA, which you're required to start emptying after you're 70 and a half. The other big differences: Roth IRA contributions aren't tax-deductible, but withdrawals from the account are tax-free after you're over 59 and a half and have owned it for at least five years.

Okay -- so what are the rules for a Roth IRA beneficiary?

A surviving spouse can become the new owner by rolling the account into a Roth IRA in his or her own name.  But all other beneficiaries must start emptying the account. Your daughter will have to take distributions from your Roth IRA when she inherits it.

If she doesn't, tax penalties will devour the account. The penalty for missing a required distribution is 50% of the difference between the amount she takes from the Roth IRA and the amount she's required to withdraw. In other words, if the mandatory annual distribution is $3,000, and she doesn't take any distribution, the penalty is $1,500.

The good news is that her distributions from the Roth IRA, like yours, are income tax-free.

What’s more, if she handles them the right way, she can keep most of the account growing tax-free for years.

A Roth IRA beneficiary who isn't a surviving spouse has two choices:

Her best option is to start taking minimum annual distributions by December 31 of the year after the account owner's death. The distributions are based on the beneficiary's life expectancy. (For how to calculate the right amount, see 'Do IRA Beneficiaries Get Automatic Payouts?' here ).

A young beneficiary who takes minimum annual distributions can greatly increase her inheritance because the balance in the Roth IRA keeps growing tax-free. (What if she needs more money? No problem -- she can always take a bigger withdrawal. There's no maximum annual distribution.)

The alternative option is to empty the entire Roth IRA by the end of the fifth calendar year after your death.

One more tip to mention in that note to your daughter:

When she inherits your Roth IRA, the Internal Revenue Service lets her name a beneficiary of her own to take over the account if she dies prematurely. "Let's say she has decided to take annual distributions over her 25 year life expectancy," says Barry C. Picker, a Brooklyn New York tax accountant. "The IRS lets her name her son as the beneficiary in case she doesn't live for those 25 years. He won't be able to stretch distributions over his own life expectancy. But he'll be able to take distributions over the balance of her 25 years life expectancy."

And a word of warning: Make sure your Roth IRA custodian -- the bank, broker, mutual fund or insurer that holds the account --  lets your beneficiary name a beneficiary as described above. The IRS permits it -- but some IRA custodians don't. If yours is among them, you should transfer your account to a custodian whose rules are more liberal.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.

(c) Lynn Brenner, All Rights Reserved

Inherited IRA: Does a beneficiary receive automatic payouts from the bank?

Q: I own several IRAs which are at the bank. My brother is my IRA beneficiary. Will his payouts from the IRAs be affected by how old I am when I die? (Does it make any difference whether I'm under or over 59 1/2, or under or over age 70 and a half when I pass away?)  Or will he receive automatic yearly payouts from the IRAs with the amounts recalculated based on his lifespan? -- RD via email

 

A: Nobody should rely on a bank to 'automatically' send out legally required IRA distributions!

Whether you're an IRA owner or an IRA beneficiary, you're responsible for taking those distributions -- and you'll owe the Internal Revenue Service a steep fine if you don't take the right minimum amount by the right deadline. It's up to you to give the bank the right instructions.

There are three different sets of rules for IRA beneficiaries.

The first set applies only to beneficiaries who are surviving spouses. The second set applies only to non-spouse beneficiaries -- a category that includes any person who wasn't married to the original IRA owner. The third set of rules applies only to non-human IRA beneficiaries, like trusts and charities.

The IRA owner's age at death is irrelevant unless the beneficiary is a trust or a charity -- in other words, a beneficiary that has no life expectancy, says Barry C. Picker, a Brooklyn New York tax accountant and financial planner.

Any beneficiary who has a pulse uses his own life expectancy to calculate his required distributions.

Your brother must take his first minimum annual distribution from your IRAs by December 31 of the year after your death. (If you die in 2010 -- not that I'm wishing you ill, but just as an example -- his first deadline is December 31 2011.)

His distributions will be taxable at his own income tax rate. The money that he doesn't withdraw keeps growing inside the IRAs on a tax-deferred basis.

So how much does he have to withdraw every year?

His minimum required annual distribution is based on two factors: his life expectancy, and the total balance in all your traditional IRAs on December 31 of the prior year. (The same calculation must be done separately on the total balance of any Roth IRAs he inherits from you.)

He'll find his life expectancy on the Internal Revenue Service actuarial table called `Single Life Expectancy Table For Inherited IRAs', which is at the back of IRS Publication 590, which you can download here.

Other readers take note: That table is only for inherited IRAs. If you're taking required distributions from your own IRA, you use the 'Uniform Table for Determining Lifetime Distributions'.

To determine the correct amount, your brother must divide the total balance of your IRAs (or Roth IRAs) on December 31 of the prior year by his life expectancy factor on the IRS table.

Let's put some numbers on this to make it clearer:

If your brother is 49 years old in 2011, his life expectancy factor will be 35.1. Let's say the total IRA balance on Dec. 31 2010 is $100,000. In that case, his minimum 2011 distribution is $2,849 -- $100,000 divided by 35.1. Each year, he recalculates his minimum distribution, reducing the original life expectancy number by 1, says Ed Slott, a Rockville Centre NY tax accountant. (In 2012, his life expectancy factor will be 34.1, in 2013, it will be 33.1, etc.)

One reason you can't rely on your bank to do this calculation for you is that it's based on the total balance of all your IRAs, and your bank has no way of knowing about IRAs you may have at another institution.

The Internal Revenue Service does know about all your IRAs, of course. As long as you take the correct distribution by the right deadline, the IRS doesn't care which account you take it from. To the IRS, all your traditional IRA accounts are a single pool of money. (Your Roth IRAs are a single pool, too - but a different pool.) 

I post a new Question and Answer every Monday. The next post will be on Monday, July 27.

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Can My Husband Disinherit His Kids From His Previous Marriage?

Q: I have been married for 16 years. My husband and I have four kids. He also has two older children from a prior marriage. We want to leave what we have for our own four children. How can we protect our life insurance, homes and other accounts just for our four children? We don't want the kids outside our marriage to benefit from our assets if anything happens to us. – DV, New York

 

A: If your husband really wants to disinherit his two older children, he can do it by leaving them out of his will, naming other beneficiaries on his life insurance and retirement accounts, and making you the joint owner of your houses and other financial accounts.

There's nothing illegal about this. No law requires parents to leave anything to their kids.

But you'd be wise to discourage him from following through on this plan.  

There's much more than money at stake. To disinherit a child is to deliver an irrevocable emotional blow.

And your stepchildren won’t be the only victims. Your own four children will eventually witness the pain their father has caused. Are they likely to think better of him for leaving nothing to their half-siblings?

A more generous alternative would be for him to leave them a small legacy and a loving letter expressing his hope that they will understand that it couldn’t be larger because he had to provide for a surviving spouse and four younger children. 

 

I'm Getting A Divorce. What Happens If I Die Before I Get A New Will?

Q: My wife and I are separated and will soon get a divorce. What's the fastest, easiest, and cheapest way for me to get a new will? And what happens to my assets if I die while I’m still married?  -- JA, New York

                                                           

A:  Stay healthy. 

As long as you're married, New York law entitles your wife to one-third of your estate, no matter what your new will says, unless she waived that entitlement in a prenuptial or postnuptial agreement.

 Of course, the law cuts both ways: If she dies while you’re still married, you're entitled to one-third of her assets.

 Most states have similar laws: As a matter of public policy, states don’t let citizens disinherit their spouses. The reason: When you die, the state doesn’t want to your surviving spouse to be forced to seek public assistance. In other words, these laws are really intended to protect the taxpayer.

 The quickest and cheapest way to get a new will is to do write it yourself. This only works if you use the right legal forms and complete them correctly. A good book that tells you which forms to use and provides clear instructions about how to fill them out is Nolo's Simple Will Book by attorney Dennis Clifford, which sells for about $30.

 But if your situation is at all complicated, you should seek legal advice. Ask your friends, relatives, and tax accountant if they can recommend an estate lawyer. When you have a short list of names, look them up in the Martindale-Hubble Law Directory at www.martindale.com. It provides biographical information, addresses, telephone numbers and links to their websites.                                                                         

Call the likely candidates and ask for a consultation. Ask if there's a consultation fee; sometimes there is, sometimes there isn't. (If there is, ask if it will be subtracted from the attorney’s total fee, should you hire him or her.) Some lawyers mail you a questionnaire to fill out and bring with you.

 This initial meeting doesn't commit you to anything. It's a chance to describe what you want to accomplish, hear what the lawyer recommends, and learn what he or she charges.

 A basic estate planning package includes will, a health care proxy (in which you name someone to make your medical decisions if you’re incapacitated) and a power of attorney (in which you name someone to handle your financial affairs if you can’t do it yourself.)

 Any lawyer you decide to hire should give you a written statement that explains what he or she charges and what services you can expect for that fee.