Understanding Inherited IRAs

Posted on December 28th, 2011 in Estate Planning, Newsletter Articles, Retirement Planning, Taxes by wayne

There are few areas of the tax code as confusing as inherited IRAs.  Let’s examine your current tax deferred retirement accounts (IRA, SIMPLE IRA, SEP IRA, 401(k), 403 (b), etc) and what is required to minimize taxes from an inherited tax deferred retirement account.

The single, most important step you can take to assure that your tax deferred retirement account, which I will hereafter call an IRA, can be inherited with maximum tax flexibility is to fill out the account’s beneficiary form.  Contact your IRA custodian and verify that you have a named beneficiary.

IRAs Inherited from your spouse. The most flexible inherited IRA is one that is inherited from your spouse.  Typically, the best approach for an inherited spousal IRA is to roll the assets into your own IRA.  These assets can either be comingled with an existing IRA or put into a new IRA in your name.

Due to the unique treatment of inherited spousal IRAs, it may be better to transfer the IRAs assets into an inherited IRA if:.

1) you are older than your spouse and your spouse died before age 70½.  This option would allow you to delay taking the minimum required distributions (MRDs) until the year your spouse would have turned age 70½.

2) you are younger than age 59½ and you need access to the IRA assets immediately.  An inherited IRA allows you to withdraw funds and not be subject to the 10% early withdrawal penalty that would apply to your own IRA.

Whether an inherited IRA is spousal or non spousal, be sure that it is properly retitled.  A suggested format is: “John Smith, Deceased (date of death), IRA F/B/O  (for benefit of) Mary Smith, Beneficiary.”

IRAs Inherited, other than spouse. If you inherit an IRA from a parent or other relative, you cannot roll it over into your own IRA.  To have continued tax deferred treatment of the inherited IRA assets, you must set up a properly titled inherited IRA.  The inherited IRA must be established by December 31 of the year following the year of the deceased’s death.

Once the inherited IRA is properly titled, you will have two distribution options:

1) The entire IRA must be distributed by December 31 of the fifth year following the year of the owner’s death.  If the owner died in 2011, all of the IRA must be distributed by 2016.  The timing(s) of this distribution is entirely up to the beneficiary, as long as all assets are distributed by the end of the fifth year.

2) The inherited IRA can be paid out over the life expectancy of the beneficiary, starting in the year following the owner’s death.  If the owner is over 70½ , the required minimum distribution (RMD) must also be taken for the year in which the owner died.

If the beneficiary of an IRA is a qualified trust, the two distribution options shown above apply.  However, if the beneficiaries of the trust include multiple people, the life expectancy that must be used in option 2) is the life expectancy of the oldest beneficiary.  However, if the IRA is left directly to the multiple beneficiaries, each beneficiary can choose their distribution option and the life expectancy distribution will be based on the age of each beneficiary.

Unless the inherited IRA has a “basis” (some of the contributions were made with after tax funds) all IRA distributions are taxable.  Distributions from inherited IRAs are never subject to the 10% early distribution penalty, regardless of the age of the beneficiary at the time the distribution occurs.

Inheriting a Qualified Roth IRA. A beneficiary may receive all of the assets in a qualified Roth IRA as a tax free lump sum.  However, a beneficiary has the option of establishing an inherited Roth IRA with the Roth proceeds.  With an inherited Roth IRA, the beneficiary will only be required to take a yearly distribution, based on their current age.  This allows the Roth proceeds to continue to grow on a tax free basis, throughout the beneficiary’s lifetime.

Be sure to verify that all of your retirement accounts have a named beneficiary.  If you inherit and IRA of any type, seek advice from a qualified professional before taking any actions .

An Option to Early Retirement

Posted on December 28th, 2011 in Financial Abundance, Newsletter Articles, Retirement Planning by wayne

Many of my baby boomer clients are questioning their ability to retire before they reach their Full Retirement Age (FRA) for Social Security.  When we do our annual retirement planning, we always explore several different retirement options to allow for the abundant retirement they desire.

The goal of any retirement plan is to live throughout the retirement years without depleting retirement savings.   An abundant retirement provides adequate income to continue living the current lifestyle plus additional funds to better enjoy retirement through additional activities such as travel and hobbies.   As there is a 40% probability that at least one person in a healthy 65 year old couple will live an additional 30 years, providing for an abundant retirement requires advanced financial planning.

One factor that is not often fully appreciated in retirement planning is the large “cost” of early retirement.  However, if you are actively saving for your retirement years, there is  a seldom explored option to early retirement.

The goal is often to retire at age 62, the earliest age at which Social Security payments are available.  An option to taking this early retirement is to stop making contributions to your retirement plan saving at age 62 and use these funds to better enjoy your final working years.  By doing this, retirement savings continue to grow, Social Security payments continue to increase by approximately 8% per year and your pre-retirement years can include the travel and hobbies that may have previously been unaffordable.

Let’s consider an example of how this option can help assure an abundant retirement:

Mary and John Smith, both age 61, have a combined income of $100K per year.  Throughout their careers they have saved 15% of their pretax earnings, providing them with $800K in retirement savings.  At their full retirement age (FRA) of age 66, their combined Social Security benefits will be $40,000 per year.  They have determined that they will need $80K per year to live the abundant retirement that they desire and would like to begin retirement when they are age 62 and eligible for Social Security benefits.

If John and Mary retire at age 62, their annual Social Security benefits will be reduced to $30,000.  They will need to spend $50,000 per year from their retirement savings to provide the required $80K in annual income.  Assuming no inflation and a 3% real rate of return on their investments, John and Mary could deplete their funds in 22 years, when they are only age 84.

Since both John and Mary are in good health, there is a very high probability that one or both of them will live past age 84.  They must reconsider other options if they wish to have the desired abundant retirement.

Mary and John meet with their financial planner to explore other retirement options.  Their planner suggests that they continue working until their Social Security FRA age of 66.  However, he also suggests that instead of continuing to save for retirement, they use their annual $15K in retirement savings for vacations and new hobbies that they have been postponing due to lack of funds.

When John and Mary retire at age 66, their $800K in savings, growing at just 3%, will have grown to $900,407.  At age 66, they will receive their full Social Security benefits of $40,000 annually, reducing the annual savings withdrawal to $40,000 per year.  With these changes, John and Mary’s savings will now last for 38 years.

By working an additional 4 years and spending their annual retirement savings of $15K on vacations and hobbies, John and Mary will be able to live an abundant retirement and never deplete their savings.

If your company offers a 401(k) match, continue to contribute to your 401(k) up to the company matching amount.   Take the amount contributed to your 401(k) plan out of a taxable investment account.  You will still come out ahead thanks to the “free money” contributed by your employer’s match

Retirement options need to be explored before you retire.  Work with a qualified financial planning professional to explore all of your retirement options.  A relatively small change can make a huge difference in your ability to have and maintain an abundant retirement.