Let me start by saying that I am not an attorney. However, I hope to share some information that may help people avoid significant penalties for not following the strict rules for some retirement funds.
I was recently talking with a man who had experienced an Internal Revenue Service penalty of several thousand dollars on an IRA he had inherited when his father died. He could have avoided this by following the rules for retitling and making required annual withdrawals from the fund.
There are many complicated IRS rules for individual retirement accounts, 401(k)s and other forms of retirement accounts that must be followed to comply with the law. Failure to follow these rules for the required minimum withdrawals can be mistakes that can result in a penalty equal to 50 percent of the required annual minimum distribution.
Internal Revenue Code Sec.401(a)(9) mandates that owners of traditional IRAs must begin taking the first required minimum withdrawal by April 1 of the year following the year the account owner is 70 years and six months old. The IRS penalty is 50 percent of the difference between the minimum required distribution for that year and the amount actually withdrawn. The 50 percent penalty applies for each year of failure to meet withdrawal requirements.
If a spouse inherits the IRA, the fund can be retitled in their name and rolled over into a new IRA. The fund is then handled and withdrawal requirements are the same as if it had been originated by the surviving spouse. The language for this new ownership title is very specific to meet legal requirements, so get good legal advice on this.
The process is entirely different for inheriting an IRA by a non-spouse or a child. The funds cannot be rolled over into your IRA. However, it must be properly retitled. If several people are beneficiaries, their proportional shares must be individually retitled in their names.
Non-spousal beneficiaries must make required annual withdrawals based on their age and IRS tables. If the beneficiary decides to withdraw all of the funds they will be taxed on that amount and will lose the benefits of many future years of tax shelter on the fund.
A 401(k) or similar inherited retirement fund can be retitled in the same way as an IRA. Correct titling is also critical in these instances. Leave a note about retitling for your heirs if you hold an IRA or 401(k).
Many people think that because they have a will all assets will automatically pass to their heirs in accordance with that.
However, wills do not determine where funds such as a 401(k) or IRA will go. Retirement funds usually pass to the beneficiary as designated on the forms for the retirement fund.
In many cases these beneficiaries were set up many years ago. It may have been so long ago that you may not even remember who they are. There are many events (such as births, deaths, marriages, divorces and changes in mental ability of beneficiaries) that may have occurred in the meantime. Those events should now be considered.
My friend who lost several thousand dollars on the inherited IRA did not know the rules. He did not know about changing the title and withdrawal requirements to avoid the 50 percent IRS penalty. Most people I know do not know the rules either.
There is a lot of information available on inherited retirement funds on the Internet. One that gives a general overview can be found at http://www.duanemorris.com/articles/article2961.html.
I have found one way to avoid the complex problems associated with inherited retirement funds: set up a charitable remainder trust as a beneficiary for the retirement funds. It does not require all of the changes in title or complex withdrawal rules.
The charitable remainder trust will receive the retirement funds tax-free when the owner dies. The trust pays a percentage of the funds to the people designated as your beneficiaries each year for a couple of decades. At the end of that time the balance in the fund goes to a charitable organization that you have designated. That can be one of many different qualifying organizations. One such organization might be your church.
The retirement funds are titled so that the beneficiary is the charitable trust when you die. The people you have identified as beneficiaries of the trust do not need to deal with the complexities of changing titles on the funds or withdrawal requirements.
This avoids many potential pitfalls and penalties they might otherwise encounter. Your beneficiaries simply receive an annual check for many years and treat that as regular income for tax purposes.
As stated at the beginning, I am not an attorney and am not qualified to give legal advice. My purpose is to alert readers to possible situations so that the plight of my friend may be avoided.
Seek out qualified legal or financial advice if you have concerns about final disposition of your own retirement funds.