After reading Chumpmenudo's article about trying to convert or not convert his IRA into a Roth, linked here, the comments became more fascinating than the article itself (the author did an admirable job on a scenario that is VERY complex). What I realized in the comments was how we as laypeople misinterpret what the laws of IRAs and Roths really say and more importantly, how they pass on to future generations. Now I will not call myself an expert on the subject, as this is not my primary field, but I will explain why I became interested in the matter and give some basic guidelines on some important decisions of disposing your deferred assets.
Why I became interested in how IRAs function
I have two boys, who are currently 7 and 4 years of age. With my older son, we have a clan of five families that were in daycare together at 1 year old and the 4 boys and 1 girl still consider each other the best of friends at this ripe old age, even with them being in 4 different elementary schools amongst 3 school districts. Needless to say, they only get together when the parents get together.
One of the mothers of the group got sick earlier this year. We didn't know how bad it was until we all got together about 5 months ago and one of the other parents told us it was thyroid cancer that has spread to her lungs and bones. It was misdiagnosed as benign 15 years ago, and obviously wasn't. The cold chill spread over us in that kitchen, but the news lingered over me personally for several days. (Note: Although metastasized cancer is NOT good, the 10 year survival rate of thyroid cancer is surprisingly high because she is under 45 years of age.)
I realized what bothered me was my wife had NO IDEA about our finances: wills, what we had, where we had it, and who it was designated for. She does well professionally, I do well, she can use her credit cards, and I never say anything about money because we are always healthily in budget. But if I die tomorrow, she is financially inept about the future. So I vowed to change that by 1) educating myself and how IRAs really should be disposed of and 2) putting in an amendment to the will of how to name the future beneficiaries along with whom (I think) should get what. It's not a trust, but suggestions on how to minimize the tax burden as much as possible on future generations, and I hope you use this article as suggestions as well.
My education is from reading nearly every one of Ed Slott's books. I'll boil it down to one must read and one add-on, if you desire. The must read is "The Retirement Savings Time Bomb ... and How to Defuse It." The add-on is "Parlay Your IRA." There is a second guru, James Lange, which I have not read his work, but has received excellent reviews on Amazon. Slott's books become repetitive, so if you read the one required book, you've received 98% of what you need to know and what should satisfy many of the readers here.
My goal is to break this into two parts. The first part is how does this intertwine with your estate and what will happen to your heirs. It will read more like a Q and A because I think the information can be read easier that way. The second part is how your heirs have to handle this to not get hit with maximum taxes and penalties and stretch the money for as long as possible. This is more cumbersome and will read more like a regular article.
What does IRA stand for? Although everyone would say Individual Retirement Account, you would be wrong. As per the IRS, it stands for Individual Retirement Arrangement and is arranged between you and the IRS with a third party intermediary reporting what you do.
Is a 401(K) an IRA? No, or they would be called the same thing. The 401(K) is part of the IRS code that private enterprise follows. 403(b) is what non-profits follow, and IRAs are what brokerage accounts follows. During the accumulation phase, they are virtually interchangeable, but during disposition they act very differently.
Is an IRA part of my will? No, and this is where things can get really confusing. The will is part of the legal process. The IRA (and I will refer to all deferred accounts as IRAs from here on out, unless otherwise stated) is part of the IRS and the tax code. Your will has nothing to do with your IRA accounts and who you have designated as beneficiaries. That is a COMPLETELY SEPARATE form that your brokerage firm has on file versus the transfer of the rest of your estate. If you really screw things up and have no beneficiaries or no will, then everything can go into probate where no one wins.
If an IRA has nothing to do with my will, then is an IRA part of my estate? Emphatically, yes, it is part of your TAXABLE estate. The IRS wants your money. Everything that is in your name is an asset of your estate once you die. This includes, houses, cars, furniture, computers, cash, mutual funds, stocks, bonds, IRAs (both regular and Roths), along with life insurance proceeds (if the owner of the policy was you when you die). It is ALL included in the final value to see if your estate owes any estate tax. There is an exemption of how much of the estate passes tax-free (currently at $5 million) to THOSE WHO ARE NOT YOUR SPOUSE. So, if you die on December 20, 2012 and the total value of your estate is 12 million in your name, you can have your children inherit $5 million collectively estate tax-free, and your spouse can keep the other 7 million tax-free. If she were to die on December 27th out of sheer heartbreak, then the next $5 million that she still has is passed on estate tax-free and the remaining $2 million is taxed at estate rates (currently 35% for the next 12 days).
If my will has no control on who gets my IRAs, then who does? You do, at least you still do while you are still alive. If your brokerage firm was up to snuff, when you opened the account, they made you put down beneficiaries or they would not let you open the account. If you do not know who you named or things have changed where someone should not be a beneficiary anymore, you can change it by getting the form from your brokerage company and designating new beneficiaries. KEEP A COPY WITH THE UPDATED BENEFICIARY FORM WITH YOUR WILL. Just because the will does not say who gets the IRA, it makes sense to have the forms together in case the brokerage firm screwed things up and your beneficiaries and executor have a dated form to correct their error.
How many beneficiaries should I put? At least one, and PM me to find out my real name so you can add me to the list (Just kidding). You can have as many primary and secondary beneficiaries as you would like, as long as the whole pie adds up to 100% for each tier. The advantage to this is the ability of a beneficiary recusing their portion of the estate and getting passed to the next heir that you wanted to have it, versus probate guessing who should get it. The problem that used to occur, but I believe the IRS has gotten a little more flexible on this, is when the heirs are of a wide age range and you have to use the oldest individual to stretch the distributions, minimizing the stretch. There is an easy way around this, which I will discuss in Part 2.
I am still alive, but need to take distributions because I am older than 70.5. How much do I take and can I take it all from one account?
This is a really loaded question that I will try and make the answer manageable. The first year you are required to take a minimum distribution (RMD) is the year you turn 70.5 years old. So, if your birthdate is between January 1 and June 30th, you will take the RMD the year you actually turn 70 years old on the value of your IRA of January 1 of that same year. So, the year you turn 70, the value of the IRA is $800,000 on January 1. You use the IRS Table III Uniform RMD Table and next to the age of 70, you see the number 27.4. You divide $800,000/27.4 = $29.197.08 is your minimum RMD for that year. You look at the value of the IRA starting each year on January 1 and look at the table for the age you will be and use that life expectancy number as the divisor. Pretty simple.
If you are born after July 1, you can wait until the following year to take your first RMD (the 70.5). However, you will also be required to take the age 71 RMD in the same year. Depending upon the size of the account values and the RMDs required, you may jump tax brackets so my suggestion is to take the 70 year old RMD the year you turn 70 and keep it simple. This first distribution is the only confusing one. After that, the year you turn 81 years old, for example, you will use the divisor of 17.9.
With regards to accounts, the IRS looks at each type of account separately. What I mean is if you are 73 years old (divisor of 24.7) and have a 401(K) at $400,000, two 403(b)s totaling $350,000, a SEP-IRA valued at $100,000, and a traditional IRA at $800,000, you would do the following calculations:
401k - $400,000/24.7 = $16,194.33 RMD
403b - $350,000/24.7 = $14,170.04
IRAs - ($100,000+800,000)/24.7 = $36,437.25
Total RMDs = $66,801.62
You CANNOT take the $66,800 all from the 401K without suffering a 50% penalty because you did not take each RMD from its respective pot of IRS code. You must take the $14,170 from the 403(b) pool of money, but you have the choice of taking it all from one, all from the other, or whatever percentage from each 403(b) account you decide. The same goes with the IRAs.
If you want to make your life easier, you can transfer everything to the IRA and then only have to deal with one account and one calculation and one RMD. Just make sure to do it as a trustee-to-trustee transfer so the money is never in your possession (I will leave it at that).
So I want to leave my IRAs to different people and to a charity? How do I do that so I don't screw things up? Let's leave that question for Part 2.
If others have comments or questions in the thread, I will answer them to the best of my ability. I am hoping to help in a broad sense because people will always have specifics of their own situation. If you really need help or have a real strange situation, I would go to irahelp.com to try and find an IRA advisor close to you. (Note: I have no affiliation with Ed Slott, but understand his members stay abreast of all the nuances of the tax code.)