Last week’s column concerning the options available to a non-spouse beneficiary when inheriting an IRA prompted questions about options a spouse has when inheriting an IRA. There was also some confusion concerning the five-year rule and several readers said that this option would never make sense.
First the five-year rule. Here’s an excerpt from last week’s column: “Required Minimum Distributions (RMDs) must be made by December 31st of the year after the deceased IRA owner’s death unless the IRA owner died before reaching age 70 1/2. If the owner was younger than 70 1/2, the inherited IRA may be distributed under the five year rule. Distributions can be taken as you like without penalty (still subject to income tax) as long as all assets are distributed by December 31 of the fifth year following the original IRA owner’s death.”
Avoiding a big tax hit
The five-year rule is an option, it is not mandatory. The person inheriting an IRA from an owner under the age 70 1/2 may elect to use the life expectancy method to calculate RMDs or use the five year rule. Using the five-year rule may be advantageous if someone expects their income to decline significantly and taking a larger distribution within the five year period will help meet expenses and not cause a tax nightmare.
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Example: Joe age 65, inherits a $300,000 traditional IRA from his twin brother who died last year. Joe plans to retire late next year and has earned income of $250,000. If he takes RMDs using the life expectancy method he will need to take distributions of approximately $15,000/year in 2015 & 2016. He doesn’t need the money and will have to pay income tax on this amount at a high tax rate. If Joe elected to use the five year rule he could take no distributions in 2015 & 2016 and take distributions in 2017, 2018 and 2019 when he has no earned income. He could use these distributions to meet expenses which may allow him to delay taking Social Security.
Consider these options
A spouse has several options when inheriting an IRA. They may leave the IRA as is and designate themselves as the owner, they may roll it into their own IRA, if employed and the plan allows they may roll it into a qualified employer plan or they may elect to treat the inherited IRA as a beneficiary IRA. If a spouse is not the sole beneficiary they will not be able to designate themselves as the owner and should roll their portion into their own IRA. If the spouse is under age 59 ½ and needs or thinks they may need access to the funds in the IRA they should not roll the funds to their own IRA and should establish a beneficiary IRA. Distributions from a beneficiary IRA are required but they are exempt from the 10 percent early withdrawal penalty. If the deceased spouse had not reached age 70 1/2, the five year rule is also an option.
Setting up an inherited IRA and selecting the proper distribution method can be tricky and if not done correctly could result in some unfavorable tax consequences. A consultation with a financial/tax advisor is recommended.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624