A Tale Of Two IRA Beneficiaries

This is a tale of two beneficiaries who relied on their professional advisors for recommendations on the distribution options available regarding the IRAs they inherited. Unfortunately, both individuals received improper guidance. As you will see, the minimum distribution rules for IRA beneficiaries are quite different from those for IRA account owners.

Navigating the 5-year rule

Janice died from cancer in January 2003 at age 58. Since she was single with no children, she named her sister, Marion, as sole beneficiary of both her IRA and 401(k) plan. Marion, not knowing what to do, asked her banker for help. The banker said, “You don’t have to take any money out of the IRA for 5 years. If you don’t need the money, I would suggest you roll it over to a beneficiary IRA and let it grow tax-deferred until then.” Since Marion planned to work for another 7 years, she opted to delay the distribution.

I met Marion from a client referral in November 2004, nearly two years after her sister died. She had engaged me to prepare a comprehensive financial plan as she anticipated retirement. By that time, she had already rolled Janice’s IRA over to a beneficiary IRA at the bank, but was unable to move the 401(k) because Janice’s retirement plan did not permit rollovers to non-spousal beneficiaries, so Marion left the assets with the company.

When I started my discovery process, I asked if she had taken any distributions from the accounts. She told me the story about the banker and the “5-year rule” that he explained to her nearly two years earlier. I asked her if she needed the money, and she said “no,” just as she told the banker. Then I asked if she might need the money in the next 3 years, to which she gave the same response.

Finally, I queried why she had not taken any distributions. She said, “I want the money to grow tax-deferred as long as possible and the banker told me that was 5 years.” My response was “we need to act immediately!”

Since Marion had stated her objective was to defer income taxation on the qualified assets as long as possible, the banker gave defective advice. While the “5-year rule” is certainly an option to consider (in fact, it is the default option if no other election is made), Marion had another choice. Since Janice had not yet reached her required beginning date (RBD), prior to her death (generally, age 70 1/2 ), Marion could take minimum distributions over her own life expectancy.

At age 55, the IRS estimates that Marion should live another 29.6 years (IRS Publication 590, Appendix C, Table I). If Marion had elected to wait until the end of the 5th year following the year of her sister’s death to take a distribution, she could have deferred the taxes on all of the proceeds for 5 years.

At that time, however, the full account would have to be distributed and the taxes paid. Aside from the obvious concern of a large tax bill in one year, this choice could easily place her in a higher tax bracket in the year of distribution.

When an IRA account owner dies prior to the RBD, the first distribution is required by December 31 of the calendar year following the year of the deceased IRA owner’s death. On Dec. 31, 2003 (the year of Janice’s death), her total qualified assets were $135,605 (all RMD assets must be aggregated for calculations). On or before Dec. 31, 2004, Marion had to withdraw $4,683 ($135,605 divided by 29.6 years) or she would automatically default to the “5-year rule”.