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Families are increasingly getting large chunks of their inheritances in individual retirement accounts. Some of them are finding themselves mired in messes caused by missing beneficiary forms.
Retirement accounts generally require their owners to fill out specific forms naming beneficiaries, separate from wills. When the owner dies, the designated beneficiary—if there is one—can choose to stretch those distributions across his life expectancy, giving the remaining assets more time to grow. No taxes are due until withdrawals are made.
When there isn't a designated beneficiary, the heir generally has to empty the account much sooner—and possibly get bumped into a higher tax bracket, says Jeffrey Levine, a certified public accountant and IRA consultant at Ed Slott & Co. in Rockville Centre, N.Y.
One big exception: When surviving spouses are the sole heirs, they follow different distribution rules. (For more details, see IRS Publication 590 at IRS.gov.)
Although it seems pretty simple to fill out a form saying who should inherit an account, the devil is in the details. Longtime account holders sometimes make changes that result in opening what are effectively new accounts, with new account numbers. And beneficiary forms can get lost, forgotten or simply neglected in the shuffle.
Deborah Harris, a Delaware retiree, and her two sisters inherited IRAs from her 70-year-old brother, John Heebner, when he died last year. He had been careful to fill out all the required beneficiary forms for every account with their names, according to Ms. Harris's son-in-law, Christopher Kamnitsis, senior vice president of Beacon Financial Group, a financial-planning firm in Flemington, N.J.
But when Mr. Heebner switched his largest IRA to a brokerage IRA at the same investment firm, the account number changed. That meant Mr. Heebner needed to fill out a new beneficiary form to match the new account number—but he didn't realize the need to redo the form, and his family contends that the company didn't tell him.
"My brother wasn't stupid," Ms. Harris says. "I'm assuming he thought the beneficiary form was there" as it was for his other IRAs.
When people inheriting an IRA are named on a beneficiary form, they can stretch withdrawals across their life expectancy, using a formula set by the Internal Revenue Service. The advantage: Small withdrawals can be taken over many years, allowing the account's pretax assets to increase in value and the heirs to postpone paying taxes until they take distributions.
It is a good idea for IRA owners to give their beneficiaries copies of those forms during their lifetimes, says Jay Starkman, a CPA in Atlanta. One IRA custodian took more than a year to find Mr. Starkman's own mother's beneficiary form, nearly causing him to miss the deadline for taking the first required minimum distribution.
But when the heirs aren't specifically named on a beneficiary form, they have to empty the account sooner, as noted above.
And in some states, including Florida, where Ms. Harris's brother lived, such accounts have to go through probate court when there is no beneficiary form.
"All the adviser had to do was cut and paste, but he didn't do it," says Beacon's Mr. Kamnitsis. "Now, my family has lost a stretch IRA that could have lasted for generations."
To avoid such situations, investors who have made any changes in their accounts should make sure their beneficiary forms are still in place, Mr. Kamnitsis says.
Events that may require changes include changing jobs, retiring, getting married or divorced, having children or grandchildren, and converting a traditional account to a Roth IRA.
People inheriting an IRA have some paperwork to do on their end as well. When you inherit an IRA from anyone other than your spouse, you can't roll it over into your own IRA. Instead, you have to retitle the IRA so it is clear the owner died and you are the beneficiary.
If you move the account to a new custodian, make sure it is a "trustee to trustee" transfer. If the check is made out to you, the IRS will consider it a "total distribution" subject to tax, and if you are anyone other than the surviving spouse, it would effectively end the IRA.
And be aware that there are deadlines for all of these actions. If the IRA owner dies after age 70½, when required withdrawals start, and didn't yet take a withdrawal for that year, the heir has to do so by Dec. 31. If you miss the deadline, you are subject to a 50% penalty on the amount you should have withdrawn.
The deadline for the first required minimum withdrawal from the inherited account is Dec. 31 of the year following the year of the owner's death.
How do you figure out how much you are supposed to take out? The calculation is different from the way retirees figure out how much they have to take from their own accounts.
If you are a nonspouse beneficiary, look up your life expectancy on the single-life table in IRS Publication 590. Subtract one year from your initial life expectancy to figure out how much to withdraw each year.
So, for example, if your life expectancy the first year is 20 and you inherit an IRA worth $100,000, you would withdraw $5,000. The next year, you would divide the balance by 19, and so forth. Most IRA custodians will calculate that withdrawal amount for you. But you need to make sure they are using the table and math for an inherited account.
Another tip: Confirm with the IRA custodian that the code "4" will be used for distributions from an inherited account, and that it is on their 1099 form, says Mr. Starkman, the CPA. That is the code used to show that it is a distribution on account of death.
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