Surviving spouses who are designated beneficiaries of a deceased spouse's IRAs must decide whether to roll them over into their own IRAs, or leave the IRAs in the deceased spouse's name. This Practice Alert explains each alternative, and covers strategies for younger surviving spouses who may need to withdraw money from the deceased spouse's IRAs before they attain age 59 1/2.
Surviving spouse's options for decedent spouse's IRAs. A surviving spouse who is the sole designated beneficiary of the deceased spouse's IRA has a choice not available to other beneficiaries: The spouse may roll over the decedent's IRA into an IRA established in the spouse's own name, or elect to treat the decedent's IRA as the surviving spouse's own IRA. (Code Sec. 408(d)(3); Reg. § 1.408-8, Q&A 5(a)) Either way, the surviving spouse is treated as if he or she had funded the IRA.
There are three major advantages to making the spousal rollover or election:
(1) Ability to name own beneficiaries, keep IRA going longer. By making the rollover or election, the surviving spouse can name his or her own beneficiaries for the IRA and give the IRA a longer life-span if children, grandchildren or other younger family members or friends are named as beneficiaries.
The following favorable payout rules apply if the surviving spouse makes the rollover or election and thus becomes the IRA owner:
- If the IRA owner dies on or after the required beginning date (RBD, usually April 1 of the calendar year following the calendar year in which the individual reaches age 70 1/2) and designated a nonspouse beneficiary for the account, the IRA balance is paid out over the longer of:
(1) the remaining life expectancy of the designated beneficiary, using the beneficiary's attained age in the year immediately following the year of the IRA owner's death, or
(2) the remaining life expectancy of the IRA owner, using the owner's attained age in the year of his death. (Reg. § 1.401(a)(9)-5, Q&A 5(a), Q&A 5(c))
- If the IRA owner dies before the RBD, and designated a nonspouse beneficiary for the account, one of two payout methods apply depending on the terms of the IRA:
(1) Under the five-year method, the individual's entire account must be distributed no later than Dec. 31 of the calendar year containing the fifth anniversary of his death; (Code Sec. 401(a)(9)(B)(ii))
(2) Under the life expectancy method, annual RMDs are made over the beneficiary's life or over a period not extending beyond his or her life expectancy, and must begin no later than December 31 of the calendar year immediately following the calendar year in which the individual died. (Code Sec. 401(a)(9)(B)(iii); Code Sec. 408(a)(6))
By contrast, if the rollover or election isn't made, the survivor doesn't have the opportunity to name other beneficiaries for the account. Additionally, the balance remaining in the decedent's IRA will be distributed over what remains of the payout period that applied when the surviving spouse began receiving required minimum distributions (RMDs) from the decedent's account. Often, this payout period will be the surviving spouse's life expectancy. The bottom line is that if the IRA remains in the decedent's name, the tax-deferred IRA will have a shorter lifespan than if the spousal rollover or election is made.
(2) Required beginning date may be deferred. With the rollover or election, the RBD for distributions is April 1 of the year following the year in which the surviving spouse attains age 70 1/2.
However, if the IRA remains in the decedent's name, and he or she died before lifetime distributions commenced, then lifetime distributions to the spouse generally must begin by the later of:
(1) Dec. 31 of the year following the year in which the decedent died, or
(2) Dec. 31 of the year in which the decedent would have attained age 70 1/2 had he or she lived. (Code Sec. 401(a)(9)(B)(iv)(I), Reg. § 1.401(a)(9)-3, Q&A 3(b))
If the IRA owner died after required distributions began, and the rollover or election isn't made, payouts to the spouse-beneficiary must begin in the year following the IRA owner's death.
Thus, a surviving spouse who is younger than the decedent can defer the start of the payout period by making the rollover or electing to treat the decedent's IRA as her own.
(3) More favorable RMD rules. After the rollover or election, the receiving IRA is treated as if the surviving spouse had funded it. When the surviving spouse attains the RBD, he or she can compute required minimum distributions (RMDs) using the uniform life expectancy table for IRA owners age 70 and older (Reg. § 1.401(a)(9)-5, Q&A 4(a)). This table, which carries the same life expectancies which apply under the Joint and Last Survivor Table of Reg. § 1.401(a)(9)-9, Q&A 3, I of Reg. § 1.72-9) to an age 70 or older person and a survivor exactly ten years younger, results in smaller annual RMDs and a longer payout period than the Single Life Table (in Reg. § 1.401(a)(9)-9, Q&A 1) used to compute RMDs paid to a surviving spouse as beneficiary (rather than the owner) of the decedent's IRA (Reg. § 1.401(a)(9)-5, Q&A 6). Note that a separate lifetime distribution table applies if the spouse is more than ten years younger than the IRA owner. (Reg. § 1.401(a)-9, Q&A 3)
Young surviving spouses. If the surviving spouse is younger than age 59 1/2, the rollover election could have a significant disadvantage: Once the spouse elects to roll over the decedent's IRA into his or her own IRA, pre-age-59 1/2 withdrawals from that IRA generally will be subject to the 10% penalty tax on top of regular income taxes unless a Code Sec. 72(t) exception applies (e.g., withdrawals in the form of substantially equal periodic payments). For a recent illustration of this potential tax trap, see Sears, TC Memo 2010-146, where a surviving spouse got hit with a $6,000-plus penalty for making premature withdrawals from an IRA containing funds rolled over from her deceased husband's IRA.
By contrast, if the rollover election is not made, pre-age-59 1/2 withdrawals from the decedent's IRA will not be subject to the penalty tax. Under Code Sec. 72(t)(2)(A)(ii), distributions made to a beneficiary (or estate) on or after the death of the IRA owner are excepted from the 10% penalty tax. Thus, if the surviving spouse winds up tapping the decedent's retirement funds before attaining age 59 1/2, the rollover election could result in imposition of the 10% penalty tax.
IRA payout strategy for the younger spouse. The surviving spouse should keep the entire IRA balance in the decedent's name until the spouse attains age 59 1/2. This way, any withdrawals before that age will be penalty-tax-free. When the spouse attains age 59 1/2, he or she can roll over the IRA into an IRA in the spouse's own name. The regs make it clear that a surviving spouse beneficiary's election to treat the decedent's IRA as her own can be made “any time after the individual's date of death.” (Reg. § 1.408-8, Q&A 5(a))
RIA observation: In other words, the fact that the surviving spouse takes distributions from the decedent's IRA before the survivor attains age 59 1/2 won't affect his or her ability to make a rollover after age 59 1/2.
RIA observation: IRS does not explain how to determine when a retirement account owner attains age 59 1/2. However, the regs do explain when a person reaches age 70 1/2 for purposes of the required beginning date rules for distributions under Code Sec. 401(a)(9). Under Reg. § 1.401(a)(9)-2, Q&A 3, a person attains age 70 1/2 as of the date that is six months after the 70th anniversary of his birth. Presumably, the determination of when a person reaches age 59 1/2 is made in the same manner, i.e., the date that is six months after that person's 59th birthday.
RIA illustration : The 59th anniversary of Susan's birth was on July 1, 2010. Susan will be 59 1/2 on Jan. 1, 2011. Distributions from her IRAs on or after Jan. 1, 2011 are penalty-tax-free. Distributions before that date will be subject to the 10% penalty tax, unless an exception applies.
Source: Federal Tax Updates on Checkpoint Newsstand tab 8/2/2010