By Jeremy T. Rodriguez, JD
One piece of advice we commonly reiterate is, when you inherit an IRA or other Retirement plan asset, touch nothing! That’s because many transactions cannot be undone, and the IRS rarely grants relief simply because the taxpayer misunderstood the tax rules. That said, you don’t want to remain stagnant forever. We were reminded of this in a recent private letter ruling approving a proactive approach by trust beneficiaries that saved the stretch distribution.
However, before we discuss letter ruling 201840007, let’s quickly review the two important dates that IRA beneficiaries must know: (1) September 30th of the year after the IRA owner’s death; and (2) December 31st of the year after the IRA owner’s death. The first date is the beneficiary designation date. All named beneficiaries (designated beneficiaries) who remain on the account after September 30th in the year after the IRA owner’s death will be included when determining post-death required minimum distributions (RMDs). That means if we have multiple beneficiaries after this date, all will use the life expectancy of the oldest beneficiary. This translates into larger RMDs, higher taxes, and less investment returns for the younger beneficiaries. Not exactly an ideal outcome.
We often refer to this as the “cash-out date,” because that’s exactly what you should do with any nonliving beneficiaries and those who are not interested in the stretch distribution option. This is especially important if a charity is one of the beneficiaries, since a charity can never be a designated beneficiary. Having just one non-designated beneficiary remain after this date could ruin the stretch distribution option for everyone else. In such an event, post-death RMDs would be calculated under either the 5-year rule or by using the deceased IRA owner’s life expectancy, depending on whether the IRA owner died before or after age 70 ½.
The second deadline is December 31st in the year after death. An IRA with multiple beneficiaries must be split by this date for each beneficiary to use their own life expectancy for post-death RMDs. If this deadline passes and the beneficiaries have done nothing, they will be forced to the use the life expectancy of the oldest beneficiary for post-death RMDs.
But what if a non-living beneficiary remains a beneficiary after September 30th, but the IRA is split before the December 31st deadline? For example, let’s suppose Maggie had an IRA and named three beneficiaries: her daughters Jessica and Jasmine, and a charity, The Boys and Girls Club of America. Maggie dies in February 2017. Her daughters do nothing until November 17, 2018, when they finally split the IRA into three separate accounts. What happens?
Thankfully, splitting the IRA before the December 31st deadline saves our beneficiaries. Not only will Jessica and Jasmine get to stretch distributions, but they also get to use their own life expectancies! This scenario unveils a disconnect between the two rules. Under the tax code, splitting an account before the December 31st deadline is treated as if it had occurred on January 1st. Thus, an account that appears to have multiple beneficiaries as of the beneficiary designation date will be treated as multiple separate accounts for post-death RMDs. In other words, the retroactive treatment provides an escape hatch in this scenario.
In the letter ruling, a discretionary trust was named as the beneficiary. All trusts have two types of beneficiaries: primary beneficiaries and remainder (or contingent) beneficiaries. Remainder beneficiaries only receive what is left over after the primary beneficiaries exhaust their rights under the trust. Usually, this means the primary beneficiary passes away. Discretionary trusts allow post-death RMDs to accumulate in the trust and are paid out at the discretion of the trustee. This presents a problem for post-death RMDs; it means we must consider any potential remainder beneficiaries of the trust.
Here, the trust allowed the three primary beneficiaries to name their own beneficiaries after reaching age 30. That included other individuals, charities, and even creditors of the primary beneficiaries! Obviously, the last two are non-designated beneficiaries. Even though they aren’t specifically named as remainder beneficiaries, the ability for either to inherit IRA assets, however remote, ruins the stretch for everyone.
Fortunately, someone realized this, and the primary beneficiaries met before the beneficiary designation date and executed a release. The release prohibited them from naming any nonliving beneficiaries or anyone older than the oldest primary beneficiary. In the letter ruling, the IRS held that the language and timing of the release preserved the stretch distribution. As a result, the beneficiaries got to use the life expectancy of the oldest beneficiary for post-death RMDs, rather than the dreaded 5-year rule or the deceased IRA owner’s remaining life expectancy.
The approval of this proactive approach is important because, unlike our earlier example with Maggie, these trust beneficiaries couldn’t have split the account to preserve the stretch. Why? Because there is no separate account treatment when a trust is named the beneficiary! Ultimately, the lesson here is to not only understand the tax rules, but to realize how those rules apply in different situations.