11/2/2022
IRA Beneficiary -The Surviving Spouse’s choices: The Inherited IRA Option
Take-Away: A surviving spouse may wish to be treated as the beneficiary of their deceased spouse’s IRA for a couple of technical reasons. The reality is, however, that a spousal rollover of the decedent’s IRA is the most tax efficient way to deal with the IRA due to the Table used to calculate required minimum distributions (RMDs) and the possible delays in having to take an RMD.
Background: When an individual is named as the sole designated beneficiary of a decedent’s IRA, the beneficiary must normally withdraw the entire balance of the inherited IRA by the end of the year that contains the 10th anniversary of the IRA owner’s death. [IRC 401(a)(9)(H)(i).] However, if the designated beneficiary qualifies as an eligible designated beneficiary, he/she is instead generally entitled to use the more favorable life-expectancy payout. [IRC 401(a)(9)(B)(iii), (H)(ii).] A surviving spouse will qualify as an eligible designated beneficiary. As an eligible designated beneficiary, the inherited IRA balance must be distributed in annual required minimum distributions (RMDs) over the survivor’s life expectancy. Unlike the 4 other categories of an eligible designated beneficiary, a surviving spouse enjoys two special benefits when named as the beneficiary of an inherited IRA.
Note: To aid in understanding these complex rules, the following summary and examples will continue with Ben and Jeri, husband and wife, who appeared the earlier summary with regard to the spousal rollover rules.
Caution: These rules are complex, hard to follow, and practically speaking, mind-numbing.
Redetermination: If Jeri elects to continue as the beneficiary of Ben’s IRA, an inherited IRA, Jeri’s life expectancy is redetermined each year. [IRC 401(a)(9)(D); Proposed Regulation 1.401(a)(9)-5(d)(3)(iv).] Other designated beneficiaries who are not a surviving spouse must use the Single Life Table to calculate their initial RMD and then they just deduct one year each year thereafter, so their benefit payout ends in the final year of this fixed-term life expectancy. [Proposed Regulation 1.401(a)(9)-5(d)(3)(iii).] However, Jeri, as a surviving spouse eligible designated beneficiary will go back to this Single Life Table each year to recalculate her new life expectancy with regard to her RMD for that year. This has the effect of extending the payout to Jeri from Ben’s inherited IRA, a tax-deferral advantage.
Example (Redetermination): Ben dies in 2022 at age 72. Ben had two IRAs. Under one IRA Ben named his sister, Sue, as its designated beneficiary. Under Ben’s other IRA he named his wife Jeri as its designated beneficiary. Both Sue and Jeri are the same ag- 68 years. Both Sue and Jeri are eligible designated beneficiaries (Sue being less than 10 years younger than her brother, Ben.) Neither Sue nor Jeri is subject to the SECURE Act’s 10-year distribution rule. Instead, both Sue and Jeri can use the life expectancy payout from Ben’s IRA. [Proposed Regulation 1.401(a)99)-3(c)(5)(iii).] Therefore, both Sue and Jeri will have to start to take their RMDs in 2023, the year after Ben’s death, based on their life expectancy in 2023 using the IRS Table 1 (Single Life Table.) Since both Sue and Jeri will be age 69 in 2023, their life expectancy that year is 19.6 years, which is called their applicable denominator for 2023. Accordingly, in 2023 each of Sue and Jeri must each withdraw at least the December 31, 2023 inherited IRA account balance divided by 19.6.
But starting in 2024, Sue and Jeri’s RMDs will start to diverge. Sue’s applicable denominator will be, each year, the prior year’s applicable denominator, reduced by one (1.0). In 2024, Sue’s applicable denominator will be 18.6. In contrast, rather than simply deduct one year from her prior year’s applicable denominator, Jeri’s will go back to Table 1 in 2024 to redetermine her new applicable denominator to reflect her new, older, age. Jeri will turn 70 in 2024, so Jeri’s new applicable denominator will be 18.8. Consequently, for 2024, Jeri’s RMD will be slightly smaller than Sue’s. As the years progress this difference between Sue and Jeri’s applicable denominators will become more significant. 20 years after Ben’s death, if both Sue and Jeri are still living (both are then 88 years old) Sue’s denominator will drop to 0.6, less than 1.0, which means that Sue’s entire inherited IRA balance must be distributed to her no later than age 88. With Jeri’s inherited IRA, at her age 88 her applicable denominator is 6.61, so Jeri will only be required to withdraw roughly 15% of her inherited IRA at age 88 in calendar year 2042.
Comparison Example: As just pointed out, if Jeri had remained as the beneficiary of the inherited IRA from Ben, at age 88 Jeri’s denominator is 6.6 years (using the Single Life Table.) But suppose that instead of remaining Ben’s designated beneficiary, Jeri had rolled the balance of Ben’s IRA to Jeri’s own rollover IRA. At age 88, Jeri’s applicable denominator (using the Uniform Lifetime Table) for her own IRA would be 13.7. not 6.6. Thus, with a rollover IRA, Jeri would only have to withdraw 7.3% of her rollover IRA, not 15.15% of her inherited IRA.
Conduit Trust: A conduit trust is a see-through trust, the terms of which provide that, with respect to Ben’s interest in his IRA, all distributions will, upon receipt by the trustee, be paid directly to, or for the benefit of Jeri. A conduit trust for the sole benefit of Jeri qualifies for the same eligible designated beneficiary treatment as if Jeri were the beneficiary individually of Ben’s inherited IRA, including the redetermination of Jeri’s life expectancy annually. [Proposed Regulations 1.401(a)99)-4(f)(1)(ii)(A).] If Ben leaves his IRA to a conduit trust for Jeri’s benefit, the trust as the designated beneficiary of Ben’s IRA would not run out of life expectancy until Jeri attains the age 120.
Example: Ben wants his entire estate, including his IRA to solely benefit Jeri for her lifetime. However, Ben is a bit worried about Jeri’s potential to remarry, so he is not inclined to name Jeri outright as the designated beneficiary of his IRA, which might lead to a rollover. Instead, Ben leave his estate, including his IRA, to a conduit trust for Jeri’s lifetime benefit. Ben’s trust requires the trustee to distribute each year to Jeri (or apply for her benefit) the annual RMD from the inherited IRA. Ben’s trust can also provide that the trustee can withdraw and distribute to Jeri additional amounts over and above the RMD if desired or needed by Jeri. On Jeri’s death the remaining trust assets will be distributed to their two grandchildren, Jack and Jill. Because Ben’s trust is a conduit trust, of which Jeri is the sole lifetime beneficiary, the RMD distribution rules applied to the conduit trust will be the same as if Jeri were named outright as the beneficiary of Ben’s IRA. Therefore, the annual RMDs will be paid over Jeri’s life expectancy, which will be redetermined annually. Conduit trust distributions to Jeri will commence the year after Ben’s death, or later, the year after Ben would have reached age 72. (More on that rule below.)
Many individual want to leave assets in trust for their spouse, as opposed to outright, e.g. a second marriage. The tax advantages of the spousal rollover are not available with a conduit trust but if the IRA owner decides that they are not of paramount importance, such a trust will be used. As such, a conduit trust seems like a good option to consider. In Ben’s case, the IRA will be paid out to Jeri almost in its entirety if Jeri lives a long time, but Ben still controls through the trustee the timing of the IRA distributions to her (in excess of the RMDs) and whatever is left in the IRA on Jeri’s death will pass to Ben’s selected remainder beneficiaries, Jack and Jill.
Note, though, that if Ben’s primary concern was that Jeri might remarry, which might cause him to use a conduit trust for his IRA beneficiary designation, and Ben wants to further restrict Jeri’s rights in the trust by causing her trust interest to terminate upon her remarriage, this favorable spouse RMD rule would not be available to the trust. In this instance, Ben’s trust would be typically subject to the SECURE Act 10-year distribution rule for Jeri. Thus forfeiture provisions should be avoided if the goal is to use a conduit trust for a surviving spouse.
Delayed Commencement Date: The other principal advantage that is available to a surviving spouse compared to other eligible designated beneficiaries is a different commencement date if the inherited IRA owner dies young. This also applies if a conduit trust is used. The starting date for Jeri to commence taking her RMDs from Ben’s inherited IRA is later than for other eligible designated beneficiaries, if Ben dies before his age 72 birthday.
Example: Ben died before the year he would have reached age 71. Ben named Jeri as the sole beneficiary of his IRA. Jeri chooses to not rollover Ben’s IRA to her own rollover IRA. Jeri does not have to commence taking RMDs from the inherited IRA under the life expectancy payout until the later of: (i) the year after Ben’s death, or (ii) the ‘end of the calendar year in which’ Ben would have reached age 72. [Proposed Regulation 1.401(a)(9)-3(d).] This rule is of no use to Jeri unless Ben dies in his age-70-birthday year, or earlier. When Ben reaches his age-71 birthday year, the commencement date for Jeri is, in effect, the year after Ben’s death, the same as for any other eligible designated beneficiary. If Ben died in his age-70-birthday year, or earlier, Jeri will have a longer time during which she can hold Ben’s inherited IRA as its beneficiary without having to take any RMD from it. If Ben had died at a much earlier age, e.g. 40 years, then this hold-without-taking-an-RMD-period could last for decades.
Note, too, that if Ben and Jeri are fairly young when Ben dies, Jeri can take a distribution from Ben’s inherited IRA without incurring the 10% excise tax for taking an ‘early distribution.’ [IRC 72(t)(2)(A)(ii).] This, as covered previously, is in contrast to an IRA rollover, where Jeri would have to pay the 10% excise tax if she needed to access the funds held in her own rollover IRA before she is age 59 ½. .
Trap: If the surviving spouse holds the inherited IRA as its beneficiary, a retirement account inherited from someone who died prior to the end of the year in which he/she would have reached age 72, then for purposes of applying the RMD rules on the survivor’s death, the survivor is treated as the IRA owner. [IRC 401(a)(9)(B)(iv)(ll).]
Example: Ben dies before the magic date of age 71, leaving his IRA to Jeri as his designated beneficiary. Jeri does nothing, i.e. no rollover, no formal election, no naming successor beneficiaries in the case of her death. Then, Jeri dies before the end of the year in which Ben reached or would have reached age 72. Since Jeri has never named a designated beneficiary for the IRA, under the IRA custodial agreement Jeri’s estate is named as the default beneficiary. Since Jeri’s estate is not a ‘designated beneficiary’ and Jeri is deemed to have died ‘before her required beginning date’ the 5-year distribution rule will apply. To avoid this trap, Jeri should name a designated beneficiary to take over the inherited IRA on her death.
Delayed Rollover if Survivor is Older: Instead of a rollover, if the surviving spouse is older than the deceased IRA owner, there can also be a delay in taking RMDs.
Example: Assume that Ben died at age 67. Ben’s IRA is left to his wife Jeri, who is turning age 72 in the year of Ben’s death. Thus, Jeri is 5 years older than Ben. Obviously if Jeri takes Ben’s IRA and rolls it over to her own IRA, Jeri will be subject to immediately taking RMDs from her rollover IRA. However, Jeri does not have to roll over Ben’s inherited IRA at any specific time. Nor does Jeri have to take any RMDs from the inherited IRA until the year that Ben would have turned age 72, i.e. 5 years away. [Proposed Regulation 1.401(a)(9)-3(d).] In short, for the first 4 of those years Jeri just leaves the inherited IRA in Ben’s name and she takes no RMDs from it. Then, when Ben would have turned age 71, Jeri then rolls the inherited IRA into her own rollover IRA. By moving the inherited IRA assets into Jeri’s own rollover IRA exposes those assets to Jeri’s RMD obligation that use the Uniform Lifetime Table rather than the Single Life Table- the Uniform Lifetime Table will produce a smaller RMD amount that must be withdrawn and taxed.
Delay Loophold Plugged by Proposed Regulations: The Proposed Regulations address a perceived loophole in these rule that could be exploited by a surviving spouse, if a fixed 10-year payout was elected by the survivor. [Proposed Regulations 1.402(c)-2(j)(3)(iii).] This perceive abuse and how it is addressed is best explained by an example.
Example: The custodial documents that govern Ben’s IRA permit a surviving spouse to elect to use the SECURE Act’s ’10-year distribution rule’ instead of the life expectancy payout if Ben died before his required beginning date (RBD). This choice is permitted by Proposed Regulations. [Proposed Regulation 1.401(a)(9)-3(c)(5)(iii.) Jeri wants to take advantage of that 10-year distribution option and she thus elects the 10-year distribution rule. If Ben was age 67 when he died, electing the 10-year distribution rule enables Jeri to defer all distributions from Ben’s inherited IRA until his age 77-year. There would be no RMDs taken by Jeri from Ben’s inherited IRA until 10 years later. Jeri plan is to withdraw the entire balance of Ben’s inherited IRA in the 9th year, just before her obligation to empty Ben’s inherited IRA as her only-last RMD, and then roll the balance of the inherited IRA into her own rollover IRA at that time. In effect, Jeri plans to skip 9 years of RMDs. However, the Proposed Regulation provides that if Jeri is age-72 or older when she received the rollover distribution, and she had elected the 10-year distribution rule when Ben died, a portion of the distribution that Jeri receives will be deemed to be an RMD and, therefore, not eligible for a rollover. In short, Jeri will have to take a catch-up distribution at the time of the rollover to her own IRA; Jeri can only roll over what is left after this catch-up distribution to her IRA.
Conclusion: Most spouses will opt for a rollover to their own IRA for tax reasons. However, there are a few occasions where it might make sense for the surviving spouse to remain, at least for a while, as the beneficiary of an inherited IRA before they engage in a rollover.