Lynn Brenner's Family Finance

Tapping an Inherited IRA: Don't Shortchange Yourself!

Q: I have an Inherited IRA. I've chosen to take distributions from the account over five years. I'm in the second year now. I have two questions. 

First, is the distribution amount determined by the IRA's value in the first year, or does the amount change over the five years due to losses and gains in the account?

Second, I'd like to skip this year's distribution to avoid being pushed into a higher tax bracket. Is it possible to skip this year and divide the remaining distributions among the three years I have left? --PS via email

 

A: You have more freedom than you realize. 

First, it sounds as if you still have the option to take minimum annual distributions based on your life expectancy. If so, you should grab it. It's a better deal than having to empty the account within five years. 

Second, even if you stick with the five-year rule, it doesn't require annual distributions. It just says you must empty the Inherited IRA by the end of Year Five. If you want, you can skip years one through four and withdraw the entire balance at the end of year five.

"IRA custodians don't usually ask for an affirmative election of the five-year rule," says Barry C. Picker, a Brooklyn NY CPA and financial planner. In other words, you probably aren't committed to emptying the account in five years and still could switch to withdrawals based on your life expectancy.

Before explaining why that's preferable, let's quickly recap the rules. What you can and can't do with an Inherited IRA depends partly on whether you were married to the original owner. We'll keep it simple and say you inherited an IRA from your uncle Joe. 

--If you're the named IRA beneficiary, and Joe was under 70 1/2 when he died, you can a) take yearly distributions over your lifetime; or b) empty the IRA within five years. It's hard to imagine a situation in which b) would be a better choice, says Picker.

--If you're the named IRA beneficiary and Joe was over 70 1/2, he was already taking required distributions from his IRA when he died. In that case, you can a) take annual distributions based on your life expectancy; or b) take annual distributions based on Joe's remaining life expectancy had he lived. If Joe was 76, for example, he had a 22 year life expectancy. "But in this situation, you don't have the five-year option," says Picker.

--If you weren't the named IRA beneficiary, you have fewer choices. For example, perhaps Joe made you his heir in his will, but neglected to fill out an IRA beneficiary form. In that case, says Picker, the IRA beneficiary is actually Joe's estate. You inherited the estate, so you get the IRA -- but you don't get a beneficiary's option to stretch distributions over your own life expectancy. If Joe was over 70 1/2 when he died, you can take annual distributions based on his remaining life expectancy. But if Joe was younger, you must empty the IRA within five years. 

Okay -- so let's assume Joe died in 2010. You inherited his $100,000 IRA as the named beneficiary, which gives you several distribution choices. You picked the five-year option. You took a $20,000 distribution in 2010, assuming that it was required. But actually, the five-year rule just says you must empty the IRA by December 31, 2015 -- the end of the year containing the fifth anniversary of Joe's death.

By contrast, with annual distributions based on your life expectancy, you must take the first distribution by December 31 of the year after Joe's death -- i.e. December 31, 2011.

If you're 48 years old, you have a 36 year life expectancy. Each annual distribution is based on the IRA's value at the end of the prior year. If there was $80,000 in the IRA on Dec. 31 2010, your 2011 required distribution is $80,000 divided by 36 -- $2,222.

Lifetime distributions are a better choice because they minimize the amount you must take out every year. There's less of a tax bite, and less chance that a distribution will push you into a higher bracket. And as I explained in this earlier post, your inheritance has a chance to become much bigger because the IRA balance can grow tax-deferred basis much longer. And there's no downside: You're always free to take a bigger withdrawal if you need the money.

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.

 

The Pros and Cons of a Joint Account With Your Child

Q: I’m considering adding my oldest daughter’s name to my checking account. With a joint account, she could pay my bills if necessary. Are there any other advantages of doing this? Are there any drawbacks? ER via email

 

A: There are both advantages and drawbacks to adding an adult child to your bank account.

On the plus side, a joint account can serve as both a current convenience and a long-range estate plan. Your child can do your financial paperwork while you're alive. And as the surviving joint owner she'll inherit the account without going through probate -- the legal process in which a court validates your will. (It's important to add, however, that whether or not avoiding probate is important depends on where you live. In some states, probate is time-consuming or expensive. In others, it's fast and cheap.)

The downside is that joint accounts have hidden pitfalls. When they don't work as you planned, the result can be disastrous for you and for your survivors.

Let's take it for granted that your child is totally trustworthy and will never use the account except for your benefit.  The main potential problem during your lifetime is that joint accounts are subject to partition. This is a fancy legal way of saying that once your daughter’s name is on the account, her creditors can claim half of it. As a result, if she gets divorced, or becomes the defendant in a lawsuit, your money could be at risk.

The potential problem for your survivors is that a joint account could inadvertently disinherit some of them.  A hypothetical example:

If you put your daughter Emma's name on your account, she'll automatically inherit 100% of the account when you die. This is true even if your will says the account is to be equally divided between Emma and her brothers, Gregory and Pete. Your will has no legal control over jointly-owned assets. They pass automatically to the surviving joint owner.

In addition to unintentionally disinheriting two of your children, this may precipitate a permanent rift in the family. (If your kids don't get along, one can imagine a very nasty scene in which Gregory and Pete accuse Emma of grabbing their inheritance, and she replies that they're more interested in your money than they were in helping take care of you while you were alive. Not the way you want to be remembered!)

Here are two alternative ways of accomplishing your goal:

Find out if your state has a law permitting "convenience-only" joint bank accounts. With this type of account, your daughter can use your money only for your convenience. She won’t have any ownership rights in the account during your lifetime or after your death.

(A big caveat: Even if these accounts exist in your state, you may have trouble finding one. In New York State, for example, convenience-only accounts have been a legal reality since 1991; but they've never been well-publicized and few banks offer or have even heard of them. Make certain that you're getting a true convenience-only account. I'd ask the bank for a written statement that the other person named on the account won't have any ownership rights in it.)

The second alternative is to keep your accounts in your sole name and give your daughter a financial power-of-attorney. That power lets her manage the accounts for you, but it confers no ownership rights, and it ends at your death.

If avoiding probate is important to you, you can make the accounts ‘in-trust-for’ or ‘pay on death’ accounts, which automatically go to the named beneficiaries. 

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

(c) Lynn Brenner, All Rights Reserved.

Where to Keep Your IRA Beneficiary Forms

My May 12 post explained why IRA beneficiary designation forms are so important: They're the equivalent of a will for your IRAs.

I suggested that your safe deposit box is a good place to keep these forms. But I didn't make it clear that what you should keep are copies. The original forms must be filed with the IRA custodian -- i.e., the bank, brokerage, mutual fund company or other financial institution that holds the account.

Barry C. Picker, a Brooklyn NY tax accountant and IRA expert, points out that a hasty reading of my earlier post might lead some readers to the erroneous conclusion that it's okay to fill out a beneficiary form, sign it, and put it in your safe deposit box without ever submitting it to the custodian.

That could be disastrous!

"Say you filled out a form naming your son and sent it to the custodian. Now you change your mind and create a document naming your daughter, sign it, put it in your safe deposit box, but never submit it to the custodian. I don't think the daughter will get it," says Picker. "Definitely not without a fight from the son. I think what's on file with the custodian will trump it."

Just to make sure there are no misunderstandings about something so important, here's a step-by-step guide:

1. Ask your IRA custodian for a new beneficiary designation form and fill it out. (This is the easiest way to make sure you'll have a copy of the form, even if you aren't going to name a new beneficiary.)

Some custodians let you download or even complete this form online. Others simply ask you to send them written instructions, specifying the name of your beneficiary, his or her birth date and Social Security number, your relationship (e.g., spouse, son, daughter, friend), and the percentage of the account this person is to receive.

2. Make a copy of what you send the custodian, for your own records. You need this copy to prove that you submitted one, in case the custodian loses it.

3. Write a cover letter to go with the form. In your cover letter, you'll ask the custodian to send you written confirmation that he has received your beneficiary designation form.

4. Make a copy of the cover letter for your own records.

5. Send the original beneficiary designation form, along with the cover letter, to the IRA custodian.

6. Stay on top of the situation by making sure you receive that written acknowledgement.

6. Put your copy of the form, your copy of the cover letter, and the custodian's letter of acknowledgement in a safe place. It doesn't have to be a safe deposit box. But wherever it is, you should make sure that your executor and/or your lawyer knows where to find it.

You can change your IRA beneficiary designation as many times as you wish. Just make sure you always date it, and always have a copy of the current form.

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

(c) Lynn Brenner, All Rights Reserved.

When IRA Beneficiary Forms Are Missing, Who Inherits?

Q: You’ve written about the importance of IRA beneficiary designation forms, and about how banks and brokers sometimes lose them. What happens if my children can't find my IRA beneficiary forms after I’m dead? Does it mean that they won’t inherit the account? –LR via email

 

A: Not necessarily. They may still get your IRA, depending on how your will is worded. But they'll have to empty the account and pay taxes on it much faster than they would if they’d inherited it as the designated beneficiaries.  

Let’s start with the ideal: Imagine you leave a $400,000 IRA to your 40-year-old daughter, naming her on the beneficiary designation form, which you keep in your safe deposit box, attached to your will with a paperclip.

As the designated beneficiary, your daughter can stretch her annual withdrawals from the account over her 43.6 year life expectancy. (Her first required minimum withdrawal would be $9,174 -- $400,000 divided by her 43.6. life expectancy) Her withdrawals are added to her taxable income every year,  but the IRA balance keeps growing untaxed. If she takes only the minimum required distributions every year and earns a decent investment return, the IRA could be worth more than $1 million by the time she's 65.

The less happy version: Your IRA beneficiary form is missing. Your estate is the default beneficiary. If your will says that your daughter inherits your estate, she still gets the IRA – but not on such favorable tax terms because your estate is the designated beneficiary, and it has no life expectancy over which to stretch distributions.

How quickly the IRA must be emptied in this case depends on your age when you died.

 If you were younger than 70 and a half, the law says the IRA must be emptied within five years of your death. If you were older than 70 and a half , it must be emptied over what the IRS actuarial table says was your remaining life expectancy. (If you died at age 75, that would be 13.4 years, for example.)

Either way, your daughter gets the IRA but loses decades of untaxed investment growth.

Finally, of course, there’s the worst turn of events: You assumed your daughter would get the IRA, so your will leaves the rest of your estate to someone else – say, to your trophy second wife. Even if your daughter is named in the will, she'll have to share the IRA with her stepmother. They'll also share it if there is no will. (When you die without a will, your estate is divided between your surviving spouse and children.)

And if there's a will, but it doesn't name your daughter, the missing IRA beneficiary form could result in disinheriting her. 

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

(c) Lynn Brenner, All Rights Reserved.