Inherited IRAs: planning tips for non-spouse beneficiaries of IRAs, 401(k)s.

• Author: Franklin, Joyce L.
• Position: EstatePlanning

A young woman came to me recently looking for help in sorting out her investments after her mother's death. Her mother was diagnosed with a terminal illness in 2000 and died in 2002. Unfortunately, the mother's overall financial planning was inadequate and resulted in major restrictions faced by her heirs.

The rules in this article relate only to IRAs and retirement plans inherited by non-spouse beneficiaries; spousal beneficiaries are subject to different rules.

The Starting Point

My client and her sister each inherited 50 percent of three retirement accounts: a traditional IRA, a Roth IRA and a company-sponsored 401(k). The mother was not married at the time of her death.

The default rule for withdrawal from these plans by non-spouse beneficiaries is to begin minimum required distributions by Dec. 31, 2003, the year after the account owner's death. The alternative is to withdraw the balance of the account's assets within five years of the date of death.

For each option, income tax (but no penalty) will be due on the amount withdrawn from the IRA and 401(k) accounts. Roth IRA distributions are subject to special rules, which are detailed below.

We split each of the retirement accounts into two more accounts with the prior custodian, effectively transferring the ownership to my client and her sister. My client complied with the minimum required distribution rules and took the first distribution from her inherited retirement plans in 2003. She will continue to stretch out the retirement plans over her lifetime until the accounts are exhausted.

Calculating IRA Minimum Required Distributions

The beginning MRD for each retirement account is determined by the non-spouse beneficiary's age in the year after the account owner's death. In this case, we divided the Dec. 31. 2002 balance in the IRA by 51.4, the factor for a 32-year-old from the Single Life Table [Section 1.401(a)(9)-9, A-1].

My client's 50 percent share of the IRA balance was $160,000 on Dec. 31, 2002, therefore her first year distribution in 2003 was $3,171.21. Each subsequent year, the MRD will be determined by taking the prior year Dec. 31 account balance and multiplying it by the factor for her age in the distribution year.

Distributions from the traditional IRA will be taxable at my client's marginal tax rate. Any after-tax IRA contributions must be allocated proportionately to each distribution and will avoid tax.

Generally, the best time to take distributions from an IRA is...