IRA Inheritance – Not Taking Timely Distributions

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A comment on the post about splitting inherited IRAs sparked this particular post – the 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 the 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?

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. Your mother 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… In this example, you didn’t realize that you needed to begin taking Required Minimum Distributions (RMDs) 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:

1. take the entire balance of the IRA as a distribution before the end of the fifth year; or
2. “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 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 five years following the year of the original IRA owner’s death. In the example we’ve started, this means that you have roughly a year to complete the 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 – versus taking the other route, unwinding the mistake.

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 year’s distribution.

Continuing the example, you subtract 1 from the Table I value, 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. Subtract $1,808.32 from that figure to come up with an end of year balance of $103,191.68. Your Table I factor is 54.3, yielding an RMD of $1,900.40.

For the third year, your IRA has now 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 (missed) years. This amount is subject to ordinary income tax (just like your other income), 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 also 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 half of what you take out in the RMDs, since you hadn’t had that money in your hands anyhow.

For the current (fourth) 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 52.3, which provides you with an RMD of $2,213.43, which you need to take as a distribution by the end of the year. (You’ll need to continue this RMD calculation process for each year hereafter until your death or the IRA is fully distributed. You can always take a larger distribution, but you have to at least take the minimum.)

Don’t Try This At Home, Kids

I know I’ve cautioned you about this before, and perhaps you see it as 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. 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 in the example is your parent is not critical to the facts of this explanation – 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 belonged specifically to the decedent (your mother) and is not an IRA that she inherited from someone else. If you’ve inherited an IRA that was already an inheritance, if it was specifically directed to you as the designated contingent beneficiary then the rules are the same. But if you received the IRA via the estate (because you were not named as a beneficiary on the IRA documents), 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.