By Andy Ives, CFP®, AIF®
A spouse beneficiary of an IRA faces many decisions. There is great flexibility and many items to consider. For example, how old was my spouse when he or she passed and what impact will that have on my available choices? Do I need money now? How can I minimize my tax burden? Will penalties apply if I withdraw from the account? By systematically considering each question and leveraging the rules, a spouse beneficiary can create a unique plan that fits his or her needs. After all, with the loss of a spouse, the last thing anyone wants to deal with is money problems derived from poor planning.
Example 1: Married couple John and Janet are both 55 years old. John dies and leaves his traditional IRA to Janet. Janet will need immediate access to the account to cover living expenses. Based on these facts, the decision is clear. Janet should establish an inherited IRA. By choosing this route, she will have full access to the account penalty-free. Of course, taxes will still be due, but at least Janet can avoid the under-age 59 ½ 10% early withdrawal penalty.
By choosing an inherited IRA, Janet will accomplish several goals. Since John died before his required beginning date, Janet can delay any required minimum distributions (RMDs) from the account until John would have been age 72. Then, when Janet is actually 59 ½, she can do a spousal rollover and move the remaining balance of the inherited IRA into her own IRA. At that point, when she is over 59 ½, there is no more 10% penalty to be concerned with, so consolidating accounts makes sense. There is no time limit for when a person must complete a spousal rollover.
Oftentimes a surviving spouse, based on misinformation, will jump to an erroneous decision. There are numerous real-life examples where poor planning and a general misunderstanding of the spousal inheritance rules lead to disaster. In one case, a young widow elected a spousal rollover of a $2.6 million IRA. She then took a $997,000 distribution. Since she was under 59 ½, a 10% penalty of $97,000 applied.
Example 2: Ed (age 73) and Edna (age 65) are a married couple. Edna dies and leaves her IRA to her husband Ed. Ed has plenty of money and is trying to reduce income to minimize taxes. Ed and his financial advisor evaluate the options. If Ed does a spousal rollover, all of Edna’s IRA money will immediately be moved into Ed’s IRA. Since Ed is already taking RMDs, this new influx of cash will increase his IRA balance, thereby increasing his future RMDs and tax burden.
However, as a spouse beneficiary, Ed has other options. Another possibility is to establish an inherited IRA. Since Edna died before her required beginning date, RMDs from this inherited account can be delayed until December 31 of the year that Edna would have turned age 72. Once again, the decision is clear. Based on Ed’s primary goal of reducing income and taxes, an inherited IRA is the way to go. Ed can delay any RMDs from Edna’s account for another 7 years. If Ed’s goals change, there is nothing stopping him from withdrawing more from the inherited IRA or consolidating accounts via a spousal rollover at any time in the future.
Every scenario is different, and every person has their own set of objectives. A spousal rollover is not always the perfect fit. It is imperative to be aware of all options available. There is no need to rush into a decision. Systematically work through the alternatives and carefully consider all possibilities.