Inherited IRA's and RMD's

11/01/2010

For individuals who inherited an IRA from an IRA owner who died in 2009, December 31, 2010 may be an important deadline. This is because where there are multiple beneficiaries for the IRA, splitting up the account into several accounts no later than December 31st can procuce tax benefits for each beneficiary.

By way of background, where an IRA owner has designated several beneficiaries for an IRA, the younger beneficiaries may be at a tax disadvantage if the goal is to keep the required minimum distributions (RMDs) as small as possible and the IRA income tax deferrals going as possible.  This is because as a general rule, where there is more than one beneficiary of an IRA, the one with the shortest life expectancy (that is, the oldest one) is treated as the designated beneficiary for determining distributions.  This oldest-beneficiary rule comes into play for determining RMDs after the IRA owner's death. Regardless of whether the IRA owner died before or after his required beginning date, if the IRA owner was older than any of the beneficiaries, the remaining IRA balance at the owner's death is paid out over the remaining life expectancy of the oldest designated beneficiary.

As an example, suppose Dad named his son and daughter as equal beneficiaries of his IRA. Dad died in 2009 when he was 74. Son, age 50 this year, wants to invest the inherited IRA in emerging markets mutual funds. Daughterl, age 44 this year, wants to invest the inherited IRA in a target-retirement-date mutual fund. If the IRA is left as-is, annual RMDs for both Son and Daughter, which must commence in 2010, are based on Son's life expectancy, which is shorter than Daughter's. They may also find it hard to reconcile their differing investment philosophies.

Son and Daughter can split up the IRA into separate accounts no later than the end of the year following the year in which the decedent died. Where an IRA is divided into separate accounts (i.e., subaccounts), the RMD rules apply separately to each separate account, effective for years after the year in which the separate accounts were created, or the IRA owner's date of death, if later.

This means that if Son and Daughter direct the IRA trustee to split Dad's IRA into two separate and equal IRAs no later than December 31, 2010, with each the sole beneficiary of one of the equal IRAs, Son's RMD will be based on his table life expectancy, and Daughter's will be based on her life expectancy, which is longer than Son's. Son can invest his half of the inherited IRA in emerging markets mutual funds, and Daughterl can invest her half in the mutual fund of her choice.

For the separate or “subaccount” IRA to be treated as a separate account for RMD purposes, it must be established no later than the last day of the year following the year of the IRA owner's death. Additionally, a separate accounting must allocate all post-death investment gains and losses for the period before the separate accounts were established on a pro rata basis in a reasonable and consistent manner among the separate accounts. However, once the separate accounts are actually established, separate accounting can provide for separate investments for each separate account under which gains and losses from the investment of the account are only allocated to that account.

The key, as always, is proper planning.