Thursday, November 15, 2012

2012 Tax Planning - Splitting Inherited IRAs

For individuals who inherited a share of an IRA from an IRA owner who died in 2011, December 31, 2012 is an important deadline. This is because the regulations that govern distributions from inherited IRAs require that beneficiaries make decisions regarding the division of inherited IRAs on or before December 31 of the year following the death of the IRA owner. When there are multiple beneficiaries for an inherited IRA, splitting the IRA account into separate accounts for each of the beneficiaries has the potential to yield important tax and investment benefits.
Death beneficiaries of an IRA must take distributions from the IRA either (1) fully within five years or (2) in annual distributions over their life expectancy. The regulations that govern IRA distributions require that, whether the IRA owner died before or after his required beginning date (generally age 70 1/2), if the IRA owner was older than the beneficiaries, the remaining IRA balance is paid out over the remaining life expectancy of the beneficiary. Generally, when there are multiple beneficiaries of a single IRA, those beneficiaries must use the life expectancy of the oldest amongst them (i.e. the shortest life expectancy) when calculating the Required Minimum Distributions (RMDs). This requirement places younger beneficiaries at a disadvantage because the inherited IRA makes larger annual distributions over a shorter time, triggering potentially greater income tax liability.
For example, John designated his children, Bill and Mary, as equal beneficiaries of his IRA. John dies in 2011 at the age of 75 when Bill is age 55 and Mary is age 40. Under the default scenario, Bill's life expectancy dictates the RMDs for both Bill and Mary. Presuming they each are entitled to $500,000 from the account, in the first year the RMD using Bill's life expectancy is almost $17,000. If Mary could calculate the distribution using her life expectancy, her initial distribution would be only about $11,500. The size of the distributions will only accelerate as Bill gets older.
Fortunately for those younger beneficiaries, if they take advantage of the distribution regulations in a timely manner, they can split the IRA into separate accounts and the RMD rules will apply separately to each account. Following the split, each beneficiary will use their own life expectancy in determining the RMDs. Thus, Mary’s required distributions will be smaller than if she were required to use Bill's life expectancy. In addition, Mary would also have more freedom to invest her portion of the IRA, as her investment philosophy is likely to be more aggressive than Bill’s due to the difference in their ages.
In order to take advantage of this opportunity, recent IRA beneficiaries must direct the IRA trustee to split the inherited IRA into separate and equal IRAs no later than December 31, 2012, making each individual the sole beneficiary of their share of the IRA. Additionally, the trustee must allocate all post-death investment gains and losses for the period before the establishment of the separate accounts to each account on a pro rata basis in a reasonable and consistent manner. After establishing separate IRA accounts, each account owner can provide for separate and distinct investments depending upon the needs of the beneficiary's with gains and losses from the investment of the account allocated only to that account.
Time is running out for the beneficiaries of IRAs inherited in 2011 to make this decision. It is important that beneficiaries and their financial advisors communicate regularly to ensure the ability to take advantage of opportunities such as this. The law governing IRA distributions is both long and complex. This article addresses only the potential to split inherited IRAs into separate accounts for each beneficiary, if you have additional questions or concerns regarding IRA distributions please feel free to leave us a comment, send us an e-mail or call us.

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