These days people are concentrating more and more of their assets in their IRAs. In fact, sooner or later most people will ultimately wind up having almost all their investment assets tied up in IRAs.
Since we all know about the two certain things in life (death and taxes), it’s becoming increasingly important to beware of the rules regarding inherited IRAs.
Ignorance of these rules can lead to tax disasters, as was evidenced in a recently published tax court
case that reveals important lessons for all of us in this complex area. Don’t let this happen to you!
Let’s go through some of the events in this case and see what lessons we can learn. The basic facts of the case are pretty simple: Thomas Ozimkoski changed his will a few months before his death to leave the bulk of his property to his wife, Suzanne.
Unfortunately, Susan was his second wife and she did not get along with his son, Thomas Jr., who chose to contest the will in probate court. Even worse, even though Thomas updated his will, he never bothered to update his IRA beneficiary form – in fact it appears that he never filled one out in the first place. As we’re about to see, this led to all sorts of problems.
Lesson #1: Always Fill Out Your IRA Beneficiary Form (and keep it updated)
If Thomas had named Suzanne on his IRA beneficiary form, that money would have passed directly to her and would have totally bypassed his probate estate. Since he never filled out his form, the money instead had to go through probate, where it was subject to Thomas Jr.’s will contest action. Money that has to go through probate is subject to all sorts of problems such as creditor claims, statutory delays, etc. In contrast, IRA assets that have a clearly designated beneficiary on the form will totally avoid probate in the first place. So Thomas’ IRA money would never have been subject to the will contest if he had just filled out that form. Big mistake on his part!
Lesson #2: Inherited IRA beneficiaries have special tax advantages, but ONLY if they are named on the form
As it turns out, Suzanne wound up settling the probate action with her stepson by agreeing to pay him $110,000 from the IRA money. Unfortunately for her, this wound up costing her much more than just $110,000. Rather than leaving the money in the inherited IRA, Suzanne incorrectly rolled that money into her own IRA. Unfortunately, since she was under 59-1/2, this now meant that any distribution taken out of the IRA was not only subject to income tax, but also an additional 10% premature distribution penalty.
If Thomas had named Suzanne as beneficiary on his IRA form, she would have been eligible for much more favorable tax treatment on that money. She could have left it in the inherited IRA, rather than rolling it to an IRA in her own name. If she had done that, she could have spread the distributions over her entire life expectancy, greatly minimizing the tax impact of the distributions. Even better, she would have been eligible to take withdrawals for the rest of her life with no penalty, regardless of her age. That’s because there is an exception to the 10% penalty for money taken out of inherited IRAs…as long as there was a beneficiary named on the form. But since Thomas never filled out his form, Suzanne was out of luck.
So what should you do to make sure your own family never has to face a tax disaster like this? Follow some simple rules.
5 Simple Rules to Avoid a Tax Disaster
1) Name a beneficiary for ALL your IRAs.
2) Name an alternate, in case the first one dies before you.
3) Never name an estate as the beneficiary.
4) Make sure your IRA custodian has a copy of the beneficiary form.
5) Keep the beneficiary form updated as your circumstances change.
As you can see, inherited IRAs are no simple matter. Make sure you know the rules, and in case you feel like you could use some assistance, seek qualified counsel to help chart your course. Don’t let your family go through a tax disaster regarding your inherited IRA!