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Inherited IRA Problem-Solving

When an IRA beneficiary isn't named, there's trouble.

Natalie Choate, 11/19/2010

Do you have your own solutions/suggestions? Leave a comment at the end of the article!

The new, seventh edition (2011) of Natalie Choate's book Life and Death Planning for Retirement Benefits is at the printer! The new edition brings this classic book up to date for the latest cases, rulings, and IRS pronouncements, plus includes NEW material: "road maps" for advising clients, drafting forms, calculating distributions, etc., make everything more accessible and easy to find; a "see-through trust-tester quiz;" and extensive new coverage of aftertax money in plans, post-death choices, and everything "Roth" (including the new Small Business Jobs Act changes). Prepublication orders are now being accepted at 800-247-6553. The price is unchanged at $89.95; shipping charges are waived for prepublication orders.

The three big "stupid mistakes" in IRA planning are failing to take a minimum required distribution, rollover errors, and not naming a beneficiary. This question shows the type of mess created by the third of this unholy trio. The IRA in question is not large enough to justify legal fees to straighten out the mess, but it's big enough that the loss of deferral hurts.

Question: I'm one of four brothers. The oldest brother, Carl, died unexpectedly this year at age 54. I have been appointed as administrator of his estate. Other than his car, small bank account, and some household goods, Carl's only asset was a $75,000 IRA. He had not named any beneficiary for this account, so the account passes to his estate as default beneficiary under the IRA documents. The decedent had no will, no wife, and no children, and our parents are deceased. The estate beneficiaries are the three surviving brothers, but my surviving brothers (Dick and Harry) don't want the IRA, so they're giving their shares to me. I'd like to keep the account alive as an IRA. Can I do that? The IRA provider says my only option is to cash out the entire account right now.

Natalie: Even though this is a "small" IRA, your situation presents several complications.

The first problem is your brothers' "giving" their shares of the IRA to you. Generally nobody can "give away" either their own IRA or an IRA they've inherited. The problem is that an IRA has income taxes built into it; whoever owns that IRA "owes" income taxes on the asset, and the debt comes due when the IRA is cashed out (distributed). The tax code does not let people give away their income-tax liability. If a person (the donor) tries to give away an IRA to someone else (the donee), the tax code treats that attempted transfer as a distribution to the donor. So, for openers, if Dick and Harry really gave their shares of the inherited IRA to you, they would taxed as if they had removed the money from the IRA (income taxable event) and then made a gift to you of that amount.

In your case, they tried to give you their shares of the estate, not their shares of the "IRA," so it's not clear how this income-tax triggering treatment would apply. But, in any case, there is an escape hatch from this problem. It's called a qualified disclaimer.

If Dick and Harry, within nine months after Carl's death, filed written "disclaimers" renouncing all their rights to Carl's estate, their disclaimers would NOT be considered income-taxable transfers. The tax code concedes that a beneficiary cannot be forced to accept an inheritance! So having your surviving brothers file qualified disclaimers would eliminate this problem, on one condition: The result of a disclaimer is that the disclaimed property passes as if the person making the disclaimer had predeceased the original decedent. Disclaimers by Dick and Harry would therefore "work" to make you the sole beneficiary of the IRA only if Dick and Harry do not have children who (if Dick and Harry had actually predeceased Carl) would have inherited Dick's and Harry's shares of Carl's estate. If "removing" Dick and Harry as beneficiaries of Carl's estate only has the effect of bringing in your nieces and nephews as contingent beneficiaries, then obviously even a proper "disclaimer" will not work to get the IRA over to you as sole beneficiary. In that case the only way to shift the money to you would be for Dick and Harry to cash out their shares of the IRA (through the estate), pay income taxes on their shares, and give you what's left over. But obviously it won't be an IRA any more.

Assuming you get past that hurdle, and (through qualified disclaimers by Dick and Harry) you find yourself as sole beneficiary of Carl's estate, the next question is whether you can keep the account alive as an IRA and, if so, for how long.

The good news is that the IRA can be transferred to you from the estate as an inherited IRA. As administrator of the estate, you would instruct the IRA provider to change the name on the account from "Estate of Carl as beneficiary of Carl" to "[your name], as successor beneficiary of Carl." Following the transfer, you could close the estate and take distributions directly from the IRA. Unlike a gift from your brothers to you, a transfer from an estate to the estate beneficiary is NOT an income-taxable transfer.

The only problem here is that not all IRA providers permit these transfers. If the IRA provider you are dealing with does NOT permit estates to transfer inherited IRAs out to the estate beneficiaries, consider moving the account (still in the name of the estate) to an IRA provider who does permit such transfers.

The bad news is that, even once you have cleared all the above hurdles, the maximum payout period for this IRA is only six years (2010-2015). Because the original beneficiary of the IRA was "the estate," the option to pay the account out gradually over the life expectancy of a beneficiary is not available. An estate does not have a life expectancy. Transferring the account out of the estate does NOT change this situation, because the "applicable distribution period" is based on the original beneficiary (in this case the estate).

Thus, the best-case scenario here is that the entire account must be paid out to you (with all distributions being included in your income, unless your brother had some aftertax money in the account) no later than Dec. 31, 2015.

The moral of the story is that "small" IRAs are not necessarily "simple." Naming a beneficiary for every IRA you have can make things much easier for your survivors.

Resources: Regarding how to title an inherited IRA, and qualified disclaimers of benefits, see Chapter 4 of the new 7th edition (2011) of Life and Death Planning for Retirement Benefits. Regarding transferring inherited IRAs, see article (and list of "cooperative" IRA providers) posted at www.ataxplan.com.

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Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.
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