Things become complicated upon an IRA owner’s death. If the account holder dies before his required beginning date, or RBD, there is no required minimum due for that year. If, however, the participant dies after his RBD, the beneficiaries must take his final required minimum distribution (RMD) before December 31 of the year of death. If it is not taken, the 50% penalty applies.
After the year of death, the beneficiaries now are obligated to take their own RMDs annually. While the requirement for lifetime minimum distributions is commonly recognized, many people are unaware that RMDs continue after death. If the correct RMD is not taken, the same 50% penalty is assessed on the beneficiaries.
The rules for these required distributions are determined by two broad factors:
- Whether the participant had reached his RBD before death
- The type of beneficiary: spouse, non-spouse, trust or estate
Roth IRAs do not require lifetime RMDs. However, upon the death of a Roth IRA owner, the beneficiaries are required to take RMDs or face the same stiff 50% penalty.
Death Before the Required Beginning Date
First, we will assume that RMDs have not yet started prior to the participant’s death (he died before reaching age 70½, leaving his wife as the beneficiary). In this scenario, the spouse would have three options:
- Treat the IRA as her own and follow the RMD rules for her own IRA
- Start distributions when the participant would have turned age 70½ using her current age each year to determine the correct life expectancy factor from Table I
- Take any amount each year, but take the entire balance December 31 of the fifth year following the spouse’s death (known as the five-year rule)
If the goal is to defer taxes as long as possible, the five-year rule is probably not ideal since the entire account will be liquidated and all taxes paid within five years, which may be significantly shorter than the life expectancy of the beneficiary. However, if no distributions are made in the year after death, this option becomes the default.
It is important to remember that RMDs are just that: required minimum distributions. Any of the affected parties can always take out more than the minimum required. So electing an option that provides for the lowest minimum distribution offers the best planning opportunities. It provides the absolute least that must be taken without penalty, without compromising the option to take more at any time.
A non-spouse has two options if RMDs have not yet started prior to the IRA owner’s death:
- Distribute the balance by using the Table I factor corresponding to the beneficiary’s age on December 31 in the year following the owner’s death. Each subsequent year, she would reduce the previous year’s factor by one (rather than using the factor for the new current age each year)
- Assets can be distributed using the five-year rule.
The only option available to trust or estate beneficiaries when RMDs have not yet commenced is the five-year rule. The estate is automatically the presumed beneficiary if there is no beneficiary listed. So, it is critical that the participant names both a beneficiary and a contingent beneficiary in order to preserve the tax deferral available using the life expectancy option above.
Death After the Required Beginning Date
If, however, the participant had already started RMDs prior to death, a separate set of rules apply. Again, the spouse enjoys the most flexibility. Her options include:
- Treat the IRA as her own (like the previous scenario)
- Distribute the balance over her life using her current age each year to determine the factor used in Table I
- Distribute the account based on participant’s age as of his birthday in the year of death (if he died prior to his birthday, add one year to his age) using Table I. Then each subsequent year, reduce the previous life expectancy factor by one.
While a spouse has several options to continue pre-death RMDs, a non-spouse is left with only one option. They must use the younger of:
- Their age at year end following the year of the owner’s death or
- The owner’s age at birthday in year of death
To calculate the RMD, divide the account balance by the life expectancy factor that corresponds to that age in Table I. Each subsequent year, reduce the previous life expectancy factor by one (as opposed to looking up the new current age each year).
If multiple beneficiaries are named, it is best to establish separate accounts for each beneficiary at death so that each can utilize their own life expectancy factor. A single beneficiary account will force all of the beneficiaries to use the oldest beneficiary’s age to determine RMDs for all of them. This will force higher RMDs than necessary for the younger beneficiaries, which will accelerate taxation.
A trust or estate beneficiary has the same single option as a non-spouse, with one modification. Since a trust is not a natural person with a life expectancy, it cannot use the beneficiary’s age but is forced to use the participant’s age as of his birthday in the year of death to find the corresponding Table 1 life expectancy factor. Some Trusts can be drafted to include a “look-through provision” that names a qualified individual beneficiary or beneficiaries that qualify as individuals. However, if the estate is named, or no beneficiary is named at all, this rule applies.
In my many years as a Certified Financial Planner practitioner, I have come across situations where individuals were provided inaccurate advice from bankers, stockbrokers and even financial planners. IRA distribution planning is very complex. It requires a high level of expertise in order to make the best decisions that minimize taxes and penalties and provide the most flexibility for the individuals affected. Since the general information provided in this article is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice, I highly recommend that you consult with a Certified Public Accountant and a Certified Financial Planner professional before making any of these critical financial decisions.