One Stretch – One 10-Year

Many farmers will inherit an IRA during their lifetime.  In many cases, the surviving spouse will inherit the IRA first, and then the children will inherit whatever is left in the IRS when s(he) passes away.

But what are the rules on taking money out of the inherited IRA.  The answer, as with most of tax rules, it depends.

First, if it is a qualifying designated beneficiary, that person is allowed to continue to “stretch” it out over their lifetime.  If it is not a qualifying beneficiary, then it must be distributed over 10 years (in some cases 5 years).  Now, who is a qualifying beneficiary:

• The surviving spouse,
• Anyone who is less than 10 years younger than the deceased IRA owner,
• Disabled and chronically ill individuals, and
• Minor children, but only until they reach the age of majority and then they have 10 years.

Everyone else is required to take it out within 10 years.  We did a post last week on how that might have to be done.  It appears that the IRS has acknowledged their mistake and if you are required to take it out over 10 years, you can do a lump sum in the 10th year and nothing in the first 9 years.

But an inherited IRA can only have one “Stretch” and one “10-year” associated with it.  This means, if the person who first inherits the IRA can do a stretch, the next person is required to take it out over 10 years even if they are a qualifying beneficiary.  

If the first person has to take it out over 10 years and then passes away before the end of the 10 year period, the new beneficiary does not get 10 years; they are required to use the remaining years that were originally allowed to the person who passed.

Let’s look at some examples.

Jack passes away leaving a $1 million IRA to his wife Shirley.  She is allowed to stretch this out over her lifetime.  She lives another 25 years and then leaves the inherited IRA to her son Paul and the value is still $1 million.  Paul is required to distribute the IRA within 10 years, but does not have to make any distributions until the 10th year.  However, it is likely that he may want to take some each year to be taxed in a lower tax bracket.

Now let’s assume that Jack leaves the IRA to Paul instead of Shirley.  Paul is required to take the full amount out within 10 years.  However, he passes in year 7 leaving the IRA worth $2 million to his spouse Pauline.  She now must take it out within 3 years not 10.

What happens if someone forgets to take out their required minimum distribution (RMD).  If it is an annual requirement (such as for Shirley), there is an one-time 50% penalty that must be paid at the time the error is found and corrected.  The person will file form 5329 with the IRS and either elect to pay the penalty or ask the IRS for forgiveness.  The IRS will grant forgiveness in many cases if it is due to reasonable cause.  This is an one-time payment not a cumulative payment.

A cumulative payment applies if the RMD is equal to the full value of the IRA.  When might that apply?  In our example, if Paul or Pauline failed to take out all of the IRA by year 10, then the 50% penalty will apply each year that the IRA continues.  However, it will be limited to the value of the IRA.  This can be very easy for someone to forget; especially if they have not taken any distributions for 9 years.

The bottom line is if you inherit an IRA make sure to review all of the rules with your tax advisor.  If you mess up, it can be costly.