Self-Directed Beneficiary IRAs: RMD and Investing Tips

Photo of a man hugging his mother in the kitchen.If you’ve inherited an IRA from a parent or other 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.

Distribution Options

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 their 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

The Life Expectancy Method is the best option. Under this option, you take distributions from the inherited IRA over your life-time 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. The RMD amount changes each year as you age and as the account value grows or decreases. There is no 10% early withdrawal penalty. Traditional beneficiary IRA distributions are taxable to the beneficiary, and 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.

3. 5-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 the 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 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 time-line 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.

Buying a Retirement Home With Your Self-Directed IRA

One hand holding a pair of keys to the right of another hand with its palm opened upwards.A common question among self-directed IRA investors is, “Can I buy a future retirement home with my IRA?” Yes, you can buy a future retirement home with your IRA, but you need to understand the rules and drawbacks before doing so. First, keep in mind that IRAs can only hold investments and you cannot go buy a residence or second home with your IRA for personal use. However, you can buy an investment property with a self-directed IRA (aka “SDIRA”) that you later distribute from your IRA and use personally.

 

The strategy essentially works in two phases. First, the IRA purchases the property and owns it as an investment until the IRA owner decides to retire. You’ll need to use a SDIRA for this type of investment. Second, upon retirement of the IRA owner (after age 59 ½), the IRA owner distributes the property via a title transfer from the SDIRA to the IRA owner personally and now the IRA owner may use it and benefit from it personally as the asset is outside the IRA. Before proceeding down this path, an SDIRA owner should consider a couple of key issues.

Avoid Prohibited Transactions

The prohibited transaction rules found in IRC Section 4975, which apply to all IRA investments, do not allow the IRA owner or certain family members to have any use or benefit from the property while it is owned by the IRA. The IRA must hold the property strictly for investment. The property may be leased to unrelated third parties, but it cannot be leased or used by the IRA owner or prohibited family members (e.g., spouse, kids, parents, etc.). Only after the property has been distributed from the self-directed IRA to the IRA owner may the IRA owner or family members reside at or benefit from the property.

Distribute the Property Fully Before Personal Use

The property must be distributed from the IRA to the IRA owner before the IRA owner or his/her family may use the property. Distribution of the property from the IRA to the IRA owner is called an “in-kind” distribution, and results in taxes due for traditional IRAs. For traditional IRAs, the custodian of the IRA will require a professional appraisal of the property before allowing the property to be distributed to the IRA owner. The fair market value of the property is then used to set the value of the distribution. For example, if my IRA owned a future retirement home that was appraised at $250,000, upon distribution of this property from my IRA (after age 59 ½) I would receive a 1099-R for $250,000 issued from my IRA custodian to me personally.

Because the tax burden upon distribution can be significant, this strategy is not one without its drawbacks. Some owners will instead take partial distributions of the property over time, holding a portion of the property personally and a portion still in the IRA to spread out the tax consequences of distribution. This can be burdensome though, as it requires appraisals each year to set the fair market valuation. While this can lessen the tax burden by keeping the IRA owner in lower tax brackets, the IRA owner and his/her family still cannot personally use or benefit from the property until it is entirely distributed from the IRA. Many investors will use an IRA/LLC and will transfer the LLC ownership over time from the IRA to the IRA owner to accomplish distribution.

For Roth IRAs, the distribution of the property will not be taxable as qualified Roth IRA distributions are not subject to tax. For an extensive discussion of the tax consequences of distribution, please refer to IRS Publication 590.

Additionally, keep in mind that the IRA owners should wait until after he/she turns 59 ½ before taking the property as a distribution, as there is an early withdrawal penalty of 10% for distributions before age 59 ½.

As stated at the outset of this article, while the strategy is possible, it is not for everyone and certainly is not the easiest to accomplish. As a result, self-directed IRA investors should make sure they understand the rules – no personal use while owned by the IRA – and drawbacks – taxes upon distribution and before personal use – before purchasing a future retirement home with their IRA.