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IRA Inheritance – Not Taking Timely Distributions

inheritance by Marco BellucciA commenter from my post on splitting an inherited IRA sparked this particular post – his question was “What are the consequences for not re-titling an inherited IRA as F/B/O?”  You can see my response to that specific question at the original article

But that question sparked the idea of discussing what happens when a beneficiary doesn’t act in a timely fashion with regard to taking Required Minimum Distributions from the inherited IRA?  That’s our topic for today.

The Inheritance

So, let’s say you inherited an IRA from your mother – this was her own IRA that she had contributed to or rolled over funds from a qualified plan at some point, and had designated you as the sole primary beneficiary.  Things get really hectic and confusing after the death of a parent, and sometimes we don’t cover all of the bases properly… and in this example, you didn’t realize that you needed to begin taking Required Minimum Distributions (RMD) from your inherited IRA as of December 31 of the year following the year of your mother’s death.  As of now, for example’s sake, let’s say we’re in the fourth year after your mother’s passing. (see Notes below)

At this point you have two choices:  take the entire balance of the IRA as a distribution before the end of the fifth year; or “unwind” the mistake by taking your RMDs for the first four years, paying the 50% excess accumulations penalty on each distribution, and then continuing on with your lifetime RMDs.  In each case, of course, you would be required to pay ordinary income tax on the distributions.

Five Year Distribution

This one is the “default” distribution option – and the rules are that you must take the complete distribution (either a series of payments or a lump sum) within the five years following the year of the original owner’s death.  In the example we’ve started, this means that you have roughly a year to complete this distribution.

Since ordinary income tax is owed on distributions from your inherited IRA, if the balance is significant this could represent a sizeable tax bill for you.  It might even put you into a higher (or much higher) tax bracket, causing lots of unnecessary additional tax – if you took the other route.

Unwinding the Mistake

In order to avoid the excess taxes described above in the Five Year Distribution, you would need to go back and take distributions for the three prior years that you missed, based upon your Table I factor.  For example, let’s say your inherited IRA was worth $100,000 at the end of the year in which your mother passed away, and your age in the following year was 28.  According to Table I, your life expectancy is 55.3 years.  Dividing the IRA balance by 55.3 gives us a RMD of $1,808.32.  That’s your first distribution.

Continuing the example, you’d use Table I again along with the balance of the IRA at the end of the first year (minus $1,808.32) to come up with the RMD for the second year.  For the sake of the example we’ll assume that the IRA is growing at a fixed rate of 5% per year, and so the balance at the end of the second year is $105,000, which you subtract $1,808.32 from to come up with your balance of $103,191.68.  Your Table I factor for this year (age 29) is 54.3, yielding an RMD of $1,900.40.

For the third year, your IRA has grown to $110,250.  Subtracting your two years’ worth of RMD leaves you with $106,541.28, and your Table I factor is 53.3, giving you an RMD for the year of $1,998.90.

Adding these three years’ worth of RMDs together equals $5,707.62, which you’d take out in a distribution for the prior years.  This amount is subject to ordinary income tax (just like your W2 wages), but is also subject to a special tax on “excess accumulation”.  This tax is for failure to take RMDs in a timely fashion, and amounts to 50% of the distribution that was required, or $2,853.81.  While you could take this amount out as an additional distribution, keep in mind that you’d have to pay ordinary income tax on that amount – but at least you wouldn’t have to pay the 50% penalty on it.  You’d probably be better off just paying in half of what you take out in the RMDs, since you hadn’t had that money in your hands anyhow…

For this year, you would also need to take a RMD – and continuing our example your IRA balance at the end of last year was $115,762.50 – from which you would subtract the RMDs of $5,707.62, leaving $110,054.88.  Your Table I factor is 52.4, which provides you with an RMD of $2,100.28, which you need to take as a distribution by the end of the year.  (For this particular year, 2009, you do not have to take an RMD at all since RMDs have been waived for this year, but you’ll need to continue this RMD calculation process for each year hereafter unless other waivers are put into place.)

Don’t Try This At Home, Kids

I know I’ve cautioned you about this before, and perhaps you see it as a little self-serving (tax guy recommends a tax guy, duh!) but you can really cause yourself some extra grief if you foul this one up.  It would be worth it to have a tax professional review your calculations at the very least – and to tell the truth, you’re probably just as well to have the tax guy do the calculations for you because the cost is likely about the same for him to review your work as to do it himself.  The tax pro can help you with the required filing of Form 5329 (to account for the excess accumulation tax) as well.  In addition to the tax, interest may be owed as well on the accumulation tax due in prior years.

Notes:

It should be noted that the fact that the decedent is your parent is not critical to the facts of this example – only that you are inheriting the IRA from someone other than your spouse.  A spousal inheritance is a different animal altogether.

A factor of this example that IS important is that the IRA belongs specifically to the decedent and is not an inherited IRA.  If you’ve inherited an IRA that was already an inheritance, if it was specifically directed to you as the designated beneficiary then the rules are the same – but if you received the IRA via the estate, you’ll have to follow the five-year distribution rule exclusively.

Lastly, it is also important to note that the example only identifies a single primary beneficiary – if there is more than one beneficiary, the process described would be complicated by the fact that the oldest of all the beneficiaries (with the smallest Table I factor) would be the one whose distribution period is used for all beneficiaries, since the IRA was not split by the end of the year following the year of the death of the original owner.

Photo by Marco Bellucci

2 Comments

  1. […] depends upon the prior year’s distributions, and the calculations can get pretty messy.  See Unwinding the Mistake in the article at the link for more on how this is done. (The article applies primarily to […]

  2. IRA RulesNo Gravatar says:

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