What is the tax impact of being an IRA beneficiary?

Paul Premack, For the Express-News writes:   Dear Mr. Premack: A large part of my estate, if I were to pass away now, is contained in my IRA account. My total estate would fall below the amount for federal tax exemption. Since the money in the IRA account was placed there pre-tax, would there be tax implications to the beneficiaries or the estate upon my demise? G.E.W.

Two weeks ago, I discussed the difference between testamentary and non-testamentary assets. An IRA is non-testamentary, so it is not included in the “probate estate”. The funds in the IRA will pass to the designated beneficiaries, and are not affected by any statements in the Will. An IRA is, however, included in the “taxable estate” when determining whether the decedent’s assets are subject to federal estate tax.

You say that your total estate falls below the amount for federal tax exemption. What you mean is that the value of your taxable estate is below the exemption from estate taxes; currently, any estate below $5 million is exempt from the federal estate tax. Thus, your entire estate, including the IRA, is free of estate taxes.

But what about the income tax implications to your beneficiaries upon your demise? As you say, the funds in the IRA were deposited with pre-tax dollars. During your lifetime any withdrawals you make are included as taxable income on your own 1040 tax return. When you die, your designated beneficiaries receive the account funds and become liable for the income taxes due when the funds are withdrawn.

If the beneficiary is your spouse, the IRA can be rolled-over to an IRA in your spouse’s name. Your death does not trigger a requirement that withdrawals be made; rather, your spouse can make withdrawals as though the IRA was always owned by your spouse. After age 59 ½ withdrawals can be made without penalty, but are included in taxable income. After age 70 ½ minimum distributions are required annually and are subject to income taxes. Your spouse should also, immediately, name beneficiaries who will receive the funds when your spouse dies.

If the named beneficiary is not your spouse, one of these options should be available:

1. The beneficiary can withdraw the funds and pay the income taxes over a five-year period, or

2. The beneficiary can make required annual minimum distributions over the course of the beneficiary’s statistically determined life expectancy, paying income taxes as withdrawals are made. The IRS has a chart regarding life expectancy. This option could allow a younger beneficiary to spread out the withdrawals and thus the income taxes over many years; or

3. The beneficiary can make required annual minimum distributions over the course of the decedent’s statistically determined life expectancy, paying income taxes as withdrawals are made. Even though the IRA owner has died, the decedent may have been younger than the beneficiary (for example, naming an older brother as beneficiary). In that case, the beneficiary can continue to make annual required minimum distributions as though the IRA owner was still living, based on the IRS chart; or

4. The beneficiary can withdraw all the funds immediately in one lump sum and pay all income taxes in that year. This is the least attractive option from the perspective of paying income taxes, but if the beneficiary really needs the net balance right away this is the fastest approach.

You should ask the custodian of your IRA exactly what pay-out options are available to your beneficiaries under your specific plan. Some plans do not offer all of the legally available options. Remember when making your own Will to factor in the amounts the beneficiaries will receive from your IRA so that each heir gets exactly what you want them to get and no more and no less than you intend.