NEW YORK (CNNfn) - It seems as if I hear some war story every day from IRA beneficiaries who fall for what I call the "Five-Year Tax Trap." This occurs when a person with an IRA dies and has named a non-spouse - a child -- as his beneficiary.|
Here's an actual set of facts.
An IRA owner dies at 68 years old, before his Required Beginning Date, or RBD. (The RBD is April 1 of the year after you turn 70-1/2). He leaves a $500,000 IRA to his daughter, who is 39 years old at the time of his death in 1998. There was no estate tax on the IRA because it passed under the $675,000 estate tax exemption.
The income tax, though, is another issue.
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Unfortunately, the daughter was advised that the IRA had to be completely withdrawn by the end of the fifth year after the year of her father's death. The daughter is waiting for the five years and has not yet taken any required distributions.
She has just fallen for the Five-Year Tax Trap.
If, by the end of the five years, the IRA grows to $700,000, she must withdraw the entire account by the end of the five years. At a combined 45 percent federal and state income tax rate, the tax due on the $700,000 IRA distribution will be $315,000.
Here's the really bad news. The daughter will later find out that she did not have to withdraw the entire IRA that soon. If only she were properly advised, she could have elected out of the Five-Year Rule and instead stretched required IRA distributions over her life expectancy of 42.5 years (according to the tables found in IRS Publication 590).
An IRA that could have lasted a lifetime was lost forever. It's true that roughly half of the IRA funds are left to invest or spend, but they can no longer grow tax-deferred and the time value of money on that huge cash outlay for taxes on a 39-year-old beneficiary adds up to a loss of millions.
This happens to many IRA beneficiaries who do not know that they can elect out of the Five-Year Rule. They don't know that they can choose to stretch required IRA distributions over the rest of their lives. I hear from many beneficiaries about the "Five-Year Rule," but it should never be used if it does not have to be.
When an IRA owner dies before his RBD, a non-spouse IRA beneficiary has the following two IRS-approved distribution options: The Five-Year Rule and the Life Expectancy Method.
The Five-Year Rule
The Five-Year Rule states that the entire interest in the IRA must be distributed by Dec. 31 of the fifth year following the year of the IRA owner's death. The Five-Year Rule only applies when the IRA owner dies before his RBD. If he dies after his RBD there is no Five-Year Rule. This sounds like a good deal, but it is generally the worst option and should not be used.
The Life Expectancy Method
This is the more favorable method, but unfortunately the lesser known method, because it allows both a spouse and a non-spouse beneficiary to spread required distributions over their life expectancy.
But to get this treatment, you must elect it. This is where most beneficiaries miss the boat and end up being forced into the Five-Year Rule. If you don't elect the Life Expectancy Method, you default to the Five-Year Rule. You elect the Life Expectancy Method simply by taking your first required distribution by the end of the year after the year of the IRA owner's death.
Read Ed Slott's recent columns on the three most important decisions you'll make with your IRA: Choosing a beneficiary, picking a life expectancy and picking a distribution method.
In our example here, if the daughter had started taking required IRA distributions by the end of 1999 (the year after the year of the IRA owner's death), instead of waiting for the five years, she could have saved the huge tax bite by stretching her required distributions over the next 42.5 years.
The life expectancy election should be made in writing and filed with the IRA custodian. The IRS does not spell out any official manner in which to make the election, but I believe it would have to be in writing in order to prove you made the election.
It is also a good idea to have the financial institution (bank, broker or mutual fund custodian) send you an acknowledged copy of your election to keep for your files and most important, for your IRA beneficiary.
For those who might be thinking "What if I want the Five-Year Rule?" or "Why should I elect the life expectancy method when I am going to withdraw the entire account balance immediately, because I need the money?" You would still elect life expectancy because you never know what the future will bring.
Your financial situation may change where it turns out you would rather defer the IRA payouts over your lifetime rather than be forced to take it out under the FiveYear Rule. Even if things do not change and you need the money and want to withdraw it all in one year, you can still do that under the Life Expectancy Method.
You can always withdraw more than the required minimum. The required minimum is just that, the minimum amount that you must withdraw each year, but you can always take more and pay the tax on whatever you take.
If you are an IRA beneficiary, don't fall for the Five Year Tax Trap.