If you’ve inherited an IRA from a parent or another loved one, it is likely that you have a Beneficiary IRA. These can be powerful accounts, but you need to understand the Required Minimum Distribution (“RMD”) rules for your Beneficiary IRA to properly utilize it. The inherited IRA may be a Traditional or Roth IRA, and there are three different distribution options you may elect when you inherit the IRA. These distribution options dictate how you can invest the account. Please note that if you inherit an account from a spouse, you can just do a spousal rollover and consider the account as yours. This article is for those inheriting an IRA from a non-spouse.
You will have three distribution options upon the death of your loved one to receive the funds from their IRA. In general, the best option is the “Life Expectancy Method” as it allows you to delay the withdrawal of funds from the IRA, and allows the money invested to grow tax-deferred (Traditional) or tax-free (Roth). The three options are outlined fully below:
1. Lump Sum
The first option is to simply take a lump-sum and be taxed on the full distribution. There is no 10% early withdrawal penalty (regardless of your age or the deceased owner), but you are taxed on the amount distributed if it is a Traditional IRA. You’re also giving up the tax-deferred (Traditional) or tax-free (Roth) benefits of the account. Don’t take this option. It’s the worst tax and financial option you have.
2. Life Expectancy Method – Stretch IRA
The Life Expectancy Method is the best option. Under this option, you take distributions from the inherited IRA over your lifetime based on the value of the account. These distributions are required for Traditional IRAs and even for inherited Roth IRAs. For example, if you inherited a $100,000 IRA at age 50, you would have to take about $3,000 a year as a required minimum distribution each year and the rest can stay invested. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty when you pull money out of the account regardless of your age. Traditional Beneficiary IRA distributions are taxable to the Beneficiary while Roth IRA distributions are tax-free. And yes, Beneficiary Roth IRAs are subject to RMD even though there is no RMD for regular Roth IRAs.
There is pending legislation which the House has passed, but the Senate has sat on, which would limit the ability to stretch the IRA out to a maximum of 10 years. Even if that legislation passes, the Stretch IRA will be a good option to at least continue the tax benefits of the inherited IRA for 10 years.
3. Five-Year Method
This option is available to all inherited Roth accounts, but is only available to inherited Traditional IRAs where the deceased account owner was under age 70 1/2 at the date of their death. Under this option, the Beneficiary IRA is not subject to RMD. However, it must be fully distributed by December 31st of the fifth year following the year of the account owner’s death. There is no 10% early withdrawal penalty, and distributions are subject to tax. Again, this option is only available to Traditional accounts.
Investing with a Self-Directed Beneficiary IRA
Yes, you can self-direct your Beneficiary IRA. Before you do, make sure you understand the amount of funds you’ll need to take as an RMD, and that you will have available cash in the account to cover those RMDs. As I described above, assume you are 50 and inherited a Beneficiary IRA for $100,000. You will need to take annual distributions of around $3,000. So, if you invest all of the $100,000 into an illiquid asset, then you will be unable to take RMDs and you will force the IRA account to pay stiff penalties. Consequently, when making a self-directed investment from a Beneficiary IRA, you must take into account the amount of the investment, the total value of the account, and the timeline of the investment (when will it generate cash back to the IRA). If you inherited the $100,000 account above, you may decide to only invest $70,000 of the Beneficiary IRA into an illiquid investment (e.g. real estate or private company), while leaving the other $30,000 to be invested into liquid investments like publicly-traded stocks, CDs, cash or mutual funds. This will leave funds available for RMD until such time as the illiquid investment generates income or is sold for profit.
Stretching out the benefits of an inherited IRA can be powerful, but make sure you plan for RMDs before you make any self-directed investment from your Beneficiary IRA.
HSAs (“Health Savings Accounts”) are growing in popularity as Americans are discovering significant tax savings with these accounts. Why are they popular? There are many reasons why; some well known and others not so well known.
Let’s start with the primary benefits that are generally well known:
First, contributions to an HSA are fully deductible regardless of your income, and there is no high-income phase-out. The deduction also applies whether you itemize on your tax return or not, so everyone gets to use it. This isn’t the case for other major deductions like charitable contributions or mortgage interest, which only apply if you itemize on your tax return and itemizing is getting less common after tax reform that was enacted in late 2017. The other commonly known benefit of the HSA is that it can grow from the investments tax-free and comes out entirely tax-free to pay for or to reimburse the account owner for their qualifying medical expenses. For a quick summary of the basics and for qualifying rules, check out my partner Mark J. Kohler’s article here.
Now, lets discuss the additional benefits of an HSA that aren’t as well known:
You don’t need earned income to contribute to an HSA
Contrary to retirement plan rules for IRAs and 401(k)s, which require you to have earned income (i.e. wage, self-employment income) to contribute, you do not need to have earned income to contribute to an HSA. You can make the contribution from any source and that contribution will be a deduction against other income on your tax return (i.e. rental income, investment income, etc.).
Your spouse can inherit your HSA with no tax due
If you’ve built up an HSA that you don’t end up using, you can pass the HSA on to your spouse. A spouse can inherit the HSA and can transfer it over to an HSA in their name. The surviving spouse can then use the funds for their qualifying medical expenses during their lifetime. If the account is inherited by a non-spouse beneficiary, then the account is considered fully taxable to the person receiving the account. Non-spouse beneficiaries (i.e. children) are allowed to use the account to pay for the deceased account owner’s qualifying medical expenses for up to one year of the date of death as medical bills and expenses are determined, and then any remaining balance is distributed to the non-spouse beneficiaries and is subject to taxation.
You can self-direct your HSA and invest it into real estate or other alternative assets
Many HSA account owners just let their HSA funds sit in a savings account or they invest into mutual funds. Some place their HSA funds into a brokerage account,and buy and sell stock. And others are investing them into real estate, private LLCs, precious metals, private equity, venture capital or start-ups. Like a self-directed IRA, an HSA can be invested into all of these alternative assets and are subject to the same prohibited transaction rules and UBTI tax as IRAs and other accounts. We’ve been advising clients for years on how to self-direct their HSA and are now helping clients establish self-directed HSA accounts at Directed IRA & Directed Trust Company. We’ve seen account holders invest them into private placements, real estate, and into HSA-owned LLCs.
When you establish an IRA, 401(k), or other retirement account you are required to designate the beneficiary of that account so that the institution/custodian holding the account knows who will receive the account upon your death. You will die one day (sorry for the bad news), and without a properly completed beneficiary designation, your account will be stuck and won’t be able to be moved until a probate court orders otherwise. The form can be completed easily, so make sure you take care of this important step when establishing your retirement accounts and bank accounts.
What’s a beneficiary designation?
A beneficiary designation is simply a written and signed statement placed on record with your account custodian that specifies who receives your account upon your death. Beneficiary designations are used on IRA accounts, 401(k) accounts, HSA accounts, and life insurance policies. Beneficiary designations are used by IRA custodians, 401(k) account custodian/administrators, banks/credit unions, and life insurance companies to pass the deceased persons account on to the person(s) designated on the form without reference to the deceased person’s will, trust, and without the involvement of the probate courts. As a result, your beneficiary designation form is a powerful instrument.
You can list a primary beneficiary and secondary beneficiaries. A primary beneficiary is the first person whom you list, and this person or persons receive the account upon your passing. A secondary (aka “contingent”) beneficiary is someone you list who receives the account if the primary beneficiary is not living. For example, a common way to list your beneficiary designations is to list your spouse as your primary beneficiary and your children as your secondary beneficiary. If your spouse is not living when you die, then your account passes to your secondary beneficiary.
To have a valid beneficiary designation you must ensure the following:
- Designation: Use your institution’s/custodian’s form and designate the person(s) you desire as your beneficiary by listing their name, city/state, date of birth, and relationship to you. You can list one beneficiary or multiple beneficiaries in percentages. So, for example, if you had two children you wanted to receive the account, you would list them as 50% each on the designation form.
- Sign the designation: This may be eSigned using an eSign method accepted by your institution/custodian.
- Spousal waiver where applicable: If you have a spouse and you HAVE NOT listed your spouse as your primary beneficiary, then your spouse must sign a spousal waiver agreeing to someone else being listed as the primary beneficiary and your spouse’s signature on the waiver must be notarized. This is required as a matter of law. Failure to provide the waiver will result (at best) to your surviving spouse receiving at least half of your account upon your passing with the rest passing to your secondary beneficiaries.
- Coordinate with your estate plan: If you list your trust for estate planning as the beneficiary of your IRA, 401(k), or other retirement account, you must provide a copy of the trust to your institution/custodian. The trust must have readily identifiable beneficiaries who receive your account upon your passing and must be considered a see-through trust (most revocable living trusts are).
The beneficiary designation is the “trump card”
Your beneficiary designation is the “trump card” when it comes to estate planning documents. For example, your beneficiary designation on your retirement account or bank account will control over a will which states someone different is to receive all your assets. As a result, it is critical that you provide a beneficiary designation for every account you have, and that these designations are updated when certain major life events arise.
Action required in three common situations
If you already provided beneficiary designations on your retirement accounts, bank accounts or life insurance, it is critical that you review them and update them upon the following events:
- Divorce: There are plenty of cases when someone who failed to update their beneficiary designation passes away and their ex-spouse ends up receiving the account. This is usually contrary to the account owner’s wishes, but if you fail to update your beneficiary designations, your heirs could be in this predicament. (Talk about not leaving gracefully!) This situation is now going to be ugly for your ex, your new spouse (if you had one), and your children.
- New child: If you have a new child who was not previously identified as a beneficiary, you should update your designations to add this new child.
- New estate plan: If you establish an estate plan (will, or ideally, revocable living trust), you should ensure that your wishes in your beneficiary designations for your retirement accounts and bank accounts match-up with the terms of your trust.
When to list your trust versus your spouse/children directly
Even if you have a revocable living trust, you may want to list your spouse as your primary beneficiary. As a rule of thumb, most estate planning attorneys recommend that, for IRA or 401(k) accounts, you list your spouse as your primary beneficiary and your trust as your secondary beneficiary. The reason is that your spouse can receive your retirement account upon your passing and can do what is called a spousal rollover. This rule only applies to spouses. For example, under a spousal rollover, the retirement account of the deceased person can be transferred/rolled over into an IRA surviving spouse. This is an advantageous way for a spouse to receive a retirement account as the account is treated simply as an account of the surviving spouse, and is not subject to RMD or other quirky rules associated with inherited retirement accounts (aka “inherited IRAs” or “beneficiary IRAs”). Rather, the funds are just treated as a Traditional IRA or Roth IRA of the surviving spouse.
Your Trust can be listed second, and, in the case where your primary beneficiary is not living, certain provisions in your trust designated to protect the funds from creditors or misappropriation from inheriting children or other heirs would apply. Your children, or other heirs under your trust who are listed as secondary beneficiaries on your form would receive the funds from your retirement account in an inherited IRA (aka “beneficiary IRA”) and would have RMD requirements to remove funds from their account over their life expectancy. This is sometimes called a “stretch IRA” and is a great tax strategy as it allows them to extend the tax-free (Roth) or tax-deferred (Traditional) benefits of the account over their own lifetime.
Remember, the beneficiary designation is critical and must be completed properly. Take the extra time to get it done right, and check up on the designations on any of your existing accounts that you may be unsure of. It’s better to get these things squared away and in order now than to presume that you completed them right when you set-up the account long ago.
Summer is great time to think about college and to make financial plans for your kids. Better yet, let them make money over the summer and put it in a tax-favorable college savings account. As you consider their plan options, consider the two most common tax favored savings tools available.
There are two types of accounts that you can establish to save for higher education expenses in a tax favorable manner. These two types of accounts are Coverdell Education Savings Accounts and 529 Plan accounts.
The first type of account is known as a Coverdell Education Savings Account. A Coverdell account is typically set up for the higher education expenses of a child. The contributed funds grow in the account tax deferred and the money comes out for education expenses tax free. There is no tax deduction for amounts contributed to a Coverdell but you do have significant investment options including self-directed investment options (similar to IRA rules). A Coverdell has the following rules and benefits.
- $2,000 annual contribution limit per beneficiary (e.g. child or grandchild).
- Parents (or grandparents) can contribute without limitations to a Coverdell until a beneficiary reaches age 18 if the contributor has income of less than $190k (married joint) or $110,000 (single). For high-income earners, keep in mind that the child can always contribute to their own account with gifted funds (no need to have earned income) so you can always get around the income limitation by having the child contribute themselves.
- Funds can be used for tuition, fees, books, and equipment for college as well as certain K-12 expenses too.
- There are zero federal or state income tax deductions on Coverdell accounts.
- Accounts can be invested into stocks, mutual funds, and can even be self-directed. They operate similar to an IRA.
- Contributions grow tax-free and can be withdrawn for education expenses until the account beneficiary reaches age 30. Unused amounts can be transferred to another family member beneficiary.
The second type of account is a 529 Plan account. Contributions to 529 Plan accounts can be eligible for a state income tax deduction (depending on the state). Money contributed to a 529 Plan account is invested into a state managed fund. A 529 has the following rules and benefits.
- Amounts are invested into a state run program.
- Amounts can be withdrawn for tuition, fees, books, supplies, equipment, special needs, room and board.
- Up to a few hundred thousand dollars can be invested per beneficiary by any person.
- There are no federal tax deductions or credits for contributions.
- Many states offer tax deductions for contributions to 529 Plan accounts. For example, Arizona offers a $4,000 tax deduction for married tax filers and a $2,000 deduction for single filers. Thirty-five states offer some type of state income tax deduction for 529 Plan contributions. However, there are some states, like California, who offer no tax deduction for contributions to 529 Plan accounts. Click here to see a comprehensive list that outlines the different state funds and tax deductions (or credits for some states).
- Downside, invested amounts must be invested solely into state run programs. There are no other investment options.
In summary, Coverdell accounts have the benefit of allowing account owner’s to decide how the money will be invested with zero tax deductions available on contributions while 529 Plan accounts give you zero investment options (all funds go to state run fund) but offer state income tax deductions in most states.
If you live in a state that offers a tax deduction on contributions, such as Arizona, then the 529 Plan account is a great option if you can stomach having the money go into a state run fund. On the other hand, if you live in a state with zero income tax (e.g. Texas or Florida) or if you live in state with zero 529 Plan deductions (e.g. California) then you might as well use a Coverdell account because you’re not trading any tax deductions for investment options. For those who can’t make up their mind and who have the funds, consider doing both but do the Coverdell first. There is no restriction against doing a Coverdell account (no tax deductions, but investment options) and a 529 Plan account (possible state tax deductions but no investment options).