April 2016

Inherited IRA Situation - Daughter Dies, Then Dad Dies, Then Mom Dies

Jane Martin was age 37 in 2012 when she died. At the time she had an IRA with ABC Bank with a balance of $70,000. Her IRA account balance was due to a 401(k) rollover made in 2008 plus she had made a number of annual contributions. She had designated her dad, Tom Doe, to receive 50% of her IRA and her mom, Karen Doe, to receive the other 50%. Tom’s date of birth was June 10, 1944 and Karen Doe’s date of birth was December 15, 1950.

ABC Bank established on its computer systems two inherited IRA as follows: (“Tom Doe as beneficiary of Jane Martin’s traditional IRA”) and (“Karen Doe as beneficiary of Jane Martin’s traditional IRA.’)’

Tom designated his wife, Jane, to be the beneficiary of his inherited IRA (“Tom Doe as beneficiary of Jane Martin’s traditional IRA”) and she designated Tom to be the beneficiary of her inherited IRA (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”).

With respect to Tom’s inherited IRA, required distributions were made to him for 2013, 2014 and 2015. Tom recently died on March 13, 2016. He had not taken his 2016 RMD prior to his death.

Since he was age 69 in 2013, the initial divisor for the RMD calculation for his inherited IRA was 17.8 and the schedule to be used was:

2013 17.8

2014 16.8

2015 15.8

2016 Tom died 14.8

2017 13.8

2018 12.8

etc.

With respect to Karen’s inherited IRA, required distributions were made to Karen for 2013, 2014 and 2015. Since she was age 63 in 2013, the initial divisor for the RMD calculation for her inherited IRA was 22.7 and the schedule to be used was:

2013 22.7

2014 21.7

2015 20.7

2016 19.7

2017 18.7

2018 17.7

etc.

With Tom’s passing, Karen now has two inherited IRAs. The one she inherited from her daughter (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”) and the one she inherited from Tom. Although we at CWF have some doubts, the IRS instructions are to title this inherited IRA, “Karen Doe as beneficiary of Tom Doe’s IRA.”

Technically, these two inherited IRAs are not like-kind IRAs for purposes of applying the RMD aggregation rule since the IRAs were inherited from different people.

What RMDs need to be distributed for 2016 to Karen? She needs to be paid Tom’s RMD as calculated for her second inherited IRA as he had not taken it and she will need to take the RMD as calculated for her first inherited IRA (“Karen Doe as beneficiary of Jane Martin’s traditional IRA”)

What about the RMDs for 2017 and subsequent years? The most conservative approach for Karen is to continue to maintain two separate inherited IRAs and to take two required distributions. She would wish to designate a “new” beneficiary for each inherited IRA. As Jane had a brother, Mark Doe, Karen now designates Mark to be the beneficiary of these two inherited IRAs.

From a practical standpoint, Karen may wish to maintain only one inherited IRA. She would combine the two inherited IRAs since both had originated from her daughter’s IRA. The title should be, (“Karen Doe as beneficiary of Tom Doe’s IRA.”) The use of only one of the RMD schedules (the one requiring the larger distribution) would mean she would be withdrawing more than her true RMD amounts, but she may find maintaining only one inherited IRA worthwhile.

Upon Karen’s death, the new inherited IRA would be titled, (“Mark Doe as beneficiary of Karen Doe’s inherited IRA.”) Mark would continue use the divisor schedule being used by Karen. Current rules require the RMD divisor schedule applying to the “first” beneficiary will apply to all subsequent beneficiaries. There is no recalculation for any subsequent beneficiary.

No Form 1099-R Prepared to Report IRA Funds Moving From the Decedent’s IRA to an Inherited IRA

Some mainframe software vendors just don’t understand the IRS procedures for reporting once an IRA accountholder dies. These mainframe software writers have incorrectly adopted the approach that the Form 1099-R is to be prepared when an inherited IRA is being established.

A Form 1099-R is prepared only if there is a reportable distribution. Establishing an inherited IRA involves transferring the IRA funds from the decedent’s IRA to one or more inherited IRAs. Such transfers are not to be reported on the Form 1099-R.

Preparing a Form 1099-R which is not required to be prepared is an incorrect form and will result in penalty. The penalty is now $250 (times 2) if an IRA custodian submits an incorrect Form 1099-R

It may not be the best way, but the IRS has the IRA custodian complete the Form 5498 in a special way to inform the IRS that the decedent’s IRA funds have moved to an inherited IRA for one or more beneficiaries. Using the title, “John Doe as beneficiary of Jane Doe,” informs the IRS that funds have been moved from Jane Doe’s IRA into a inherited IRA for John Doe. The Form 1099-R is not used for this purpose.

The software vendor is causing real problems for the individual if it prepares an incorrect Form 1099-R as he or she must explain the distribution on his or her tax return. A non-spouse beneficiary is unable to rollover a distribution from an inherited IRA Putting a 0.00 in box 2a does not make things better.

IRS Biased Against Inherited Roth IRAs

The IRS should not be biased against inherited Roth IRAs, but the IRS is. Some IRS administrations are more biased against inherited Roth IRAs than others.

The IRS does not like the fact that a person may inherit a Roth IRA and earn tax-free income over the beneficiary’s life expectancy. This will be accomplished if the beneficiary limits his or her distributions to the required amount each year using the life distribution rule. This will not be accomplished if the 5-year rule is used.

The IRS last revised model Form 5305-RA in March of 2002. In Article V it is clearly stated that a beneficiary will use the life distribution rule to comply with the required distribution rules unless he or she elects the 5-year rule. The 5-year rule applies automatically if there is no designated beneficiary (e.g. the estate is the beneficiary).

Article V

1. If the depositor dies before his or her entire interest is distributed to him or her and the depositor’s surviving spouse is not the designated beneficiary, the remaining interest will be distributed in accordance with (a) below or, if elected or there is no designated beneficiary, in accordance

with (b) below:

(a) The remaining interest will be distributed, starting by the end of the calendar year following the year of the depositor’s death, over the designated beneficiary’s remaining life expectancy as determined in the year following the death of the depositor.

(b) The remaining interest will be distributed by the end of the calendar year containing the fifth anniversary of the depositor’s death.

The IRS in Publication 590-B (Distributions from IRAs), page 36, gives murky guidance discussing distributions after the Roth IRA owner’s death. “Generally, the entire interest in the Roth IRA must be distributed by the end of the fifth calendar after the year of the owner’s death unless the interest is payable to a designated beneficiary over the life or life expectancy of the designated beneficiary.” The IRS could and should be informing a Roth IRA beneficiary that if he or she elects to use the 5-year rule that one loses the right to earn tax-free income and therefore most beneficiaries should use the life distribution rule.

In recent years the IRS has adopted rules and procedures to be more fair and transparent. At times the IRS has a great conflict of interest and should make this known. The IRS should revise its discussion of inherited Roth IRAs to not try to induce a beneficiary to use the 5-year rule.