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Today we’re going to talk about individual retirement accounts, also called IRAs and how they fit into estate planning for you. Before we get into everything, we need to explain a couple of definitions because this can get a little bit complicated and a little bit murky because some of the things sound the same.

First we have the required beginning date, the RBD. This is the year after the IRA owner turns seventy and a half. It’s when they have to start taking their required minimum distributions or RMDs. The RMDs are calculated by the IRS based on your life expectancy. Throughout your life you’ve been contributing to a traditional IRA and once you hit that required beginning date, they want you to start taking money out of it. Once you start taking money out of it, they can start taxing it and start getting some of that deferred tax revenue because you’ve been writing it off throughout these years contributing it to it.

After the RBD in our MD, we have the three types of beneficiaries we’re going to talk about. A spouse, which is your husband or wife. I think we can all figure that one out. But then we have qualified beneficiaries and non-qualified beneficiaries. The qualified beneficiaries are people, some trusts, and things like that. But you need to be able to find a life expectancy. To be a qualified beneficiary and be a trust is a little more complicated and we’re going to talk about that in a later episode, but for today, it’s basically people. Kids, cousins, friends, anybody other than your spouse that has a life expectancy. And then a non-qualified beneficiary is something without a life expectancy. Most trusts, a charity, your estate, entities such as businesses or stuff like that, those are non-qualified beneficiaries. They have no life expectancy. The IRS has no idea how long they’re going to live so they want their money faster.

So first we’re going to talk about what happens if the IRA owner is not at the RBD. They have not turned seventy and a half yet. So this IRA is not in payout mode and they die. What happens then? Well, if you’re a spouse, a qualified beneficiary, or a non-qualified beneficiary, they all have one option that is common among all of them, and that is they can take all the money out within five years of that death. They can cash it all out and take it. They’re going to hit with some pretty heavy tax penalties because it’s going to be income, but they can take it all out that quick. But they have other options. If you’re a spouse, you have the ability to take it out over your own lifespan. So what happens is, if you’re not seventy and a half yet, you would actually be able to hold on to that IRA and not take any required minimum distributions until you turn seventy and a half. It basically becomes your own because you’re the spouse.

If you’re a qualified beneficiary, you have the option of the five year pay out like we already talked about, and starting the year after the death of the person, you can begin taking your own RMDs. But these RMDs are based on your lifespan, not the deceased persons. If they only had a few years left to live according to the life expectancies, their RMDs would be pretty big because the IRS wants to really deplete that account. But if you’re at 25 or at 30, your life expectancy should be much longer. So the IRS tables would say that these RMDs are going to be smaller and they’re going to go out over time so it helps you minimize the tax consequences while still receiving the money.

If you’re a non-qualified beneficiary, five-year pay out plan is your only option. You got no other choice. It has to be pulled out within five years.

Now what happens if the person has already reached the required beginning date? So their IRA is already in payout mode. This is a little bit different, since it’s already in payout mode it’s going to need to continue that way. So the spouse has the option of continuing the payouts based on their own life expectancy, not the deceased person. Say the spouse is 60 years old, but the spouse that has passed away is 75. So their IRA is getting paid out and their RMDs are based on their lifespan, their life expectancy according to the IRS. This spouse, although they’re younger would now inherit this IRA, becomes an inherited IRA, but now the RMDs are based on the spouse’s life, and he or she is younger so the RMDs are now going to be smaller and the account will last longer and hopefully get some investment gains.

If you’re a qualified beneficiary, you need to begin taking the RMDs immediately and they’re based on your life expectancy. So, you could be 20 years old and it’s going to be based on the life expectancy of a 20 year old. But an interesting thing with this is, when beneficiaries get these IRAs, but there’s multiple beneficiaries. For example, Joe Smith leaves his IRA to his three kids, kid, one kid to kid three. What they need to do is they need to split this account open, split it into three separate shares. So then each share would be based on that person’s life expectancy. Because if it’s going into a joint account with all three of them, what the IRS does is it just says, “Eeny, meeny, miny, moe, you’re the oldest, we’re using you.” They just always default to the oldest. That’s what they do. They want to get their tax revenue.

And then we go to the non-qualified beneficiary after the required beginning date. Here, they have to continue taking the RMDs based on the deceased person’s life expectancy. After the required beginning date, you can see there’s no five-year pay out. Everybody is based on the RMDs. No five-year payout, no getting it out faster. It’s strictly RMDs.

This is a little bit confusing. There are ways to try and make sure that things go smoothly and that involves making sure you have proper beneficiary plans on the IRAs, you’ve thought about the tax consequences. Maybe you decide you want to use an IRA trust to try to mitigate some of this. You can do that. The IRA trust is something with some additional complexities that I’m going to talk about in further episode, but as you can see, these are the basics of what happens when you inherit an individual retirement account or an IRA.

If you have any questions about this or any other estate planning topics, you can reach out to us by phone to schedule a consultation or schedule it online yourself.

William C. Deveneau is an attorney practicing in Southern Vermont, including Bennington and Manchester, and New York, including Albany, Colonie, Hoosick Falls, and Troy.