In TSP – Ways to Safeguard Your TSP , part 1 of this series, I discussed a significant reason why a spouse that inherits a TSP account would want to transfer their TSP account to an IRA. According to the TSP, “If a TSP beneficiary participant (Annuitant’s spouse) dies, the new beneficiary(ies) cannot continue to maintain the account in the TSP. Also, the death benefit cannot be transferred or rolled over into any type of IRA or plan.” If you are the surviving spouse and inherit your husband or wife’s TSP account, when you die your beneficiaries must claim the full amount as income the year that you die.
I previously discussed what a surviving spouse needs to consider before moving their TSP to an IRA in Survivors Beware – The TSP Trap  and in a follow up article I talked about The TSP Advantages (Should I Stay or Go) .
If the annuitant or the surviving spouse transfers his/her TSP account to an IRA the heirs can convert their share of the IRA to an “Inherited IRA” which has many benefits. According to Vanguard , “A nonspouse beneficiary has four options when receiving an IRA inheritance: inheriting the IRA, taking a lump-sum distribution, disclaiming the IRA, or electing Vanguard’s pass-through service. Each option has its own tax consequences and some options are irrevocable.”
Most either elect the Inherited IRA or take a lump sum if they need the cash now. An Inherited IRA allows heirs to grow the assets tax-deferred. Vanguard explains that, “When you inherit an IRA, you take the IRA account as a beneficiary (for your benefit) and withdraw from it over a fixed period of time without a tax penalty, regardless of age. Even if you’re under age 59½, you will not be subject to an “early withdrawal” penalty from the IRS.”
Inherited IRAs if not handled properly can trigger large tax bills and you could lose your tax-deferred status. This is especially true for nonspouse heirs and you must take the following actions to maintain your tax deferred status.
- Properly title your inherited IRA account
- Take the required minimum distributions
- Divide the IRA when there are multiple beneficiaries
- Don’t Ignore charity or non-person beneficiaries
Properly Title Your Inherited IRA account
Titling of an inherited IRA varies between IRA custodians. It is essential that the deceased IRA owner’s name remains on the inherited IRA account and the account title must indicate that it is an inherited IRA by either using the word “beneficiary” or variation there of indicating it is an inherited IRA. Here are three samples of inherited IRA titles:
- Jane Doe (deceased August 1, 2015) IRA for the benefit of John Doe
- David Smith, deceased, for the benefit of Jennifer Smith
- David Smith, beneficiary Jennifer Smith
As long as the deceased IRA owner’s name stays on the account there is no set format. However, it must be clear that the IRA is inherited. It’s important for the beneficiary of the inherited IRA to name successor beneficiaries for their account.
Take the required minimum distributions
Traditional IRAs require the owners of the account to take required minimum distributions at the age of 70 . Non spousal beneficiaries are able to spread out their inherited IRA payouts over their life time and must take their first RMD the year following the year the owner died regardless of the beneficiary’s age. You will pay tax on the distributions from deductible contributions and earnings for traditional IRAs. Non spousal beneficiaries must also take RMDs from inherited ROTH accounts however withdrawals are tax free.
There is a significant penalty for not taking an RMD, a 50% excise tax on the amount that should have been distributed that year. According to the IRS, ” Beneficiaries of retirement accounts and IRAs calculate RMDs using the Single Life Table  (Table I, Appendix B, Publication 590-B , Distributions from Individual Retirement Arrangements (IRAs)). The table shows a life expectancy based on the beneficiary’s age. The account balance is divided by this life expectancy to determine the first RMD. The life expectancy is reduced by one for each subsequent year.” There are ways to avoid the excise tax if you miss a RMD however you should look at all options before deciding on how to proceed.
Properly divide the IRA
Each non spousal beneficiary should establish their own unique inherited IRA account and titled appropriately as noted above in most cases. For example, we have two children and they are 6 years apart. If they set up a joint account for both beneficiaries they would have to use my son’s age, our oldest child, to calculate the RMD. Another more dramatic example would be if you left your IRA to an older sibling, that for this example is age 70, and to your only child, a daughter age 25. If the account remains intact and isn’t divided the daughter in this example would have to withdraw far more because of the siblings age.
Assuming that you left $200,000 to your heirs, each getting $100,000 you would determine the RMD of each heir by dividing the account balance at the end of 2016 by the appropriate life expectancy from Table I (Single Life Expectancy) in Appendix B. The daughter’s division factor would be 58.2 and your siblings 17! In this example the RMD for your sibling would be $5,882 per year and your daughter’s would only be $1,718. Your daughter would be able to accumulate more tax deferred income and investment growth over her life time and still receive an annual cash benefit. Essentially, the younger the beneficiary the less the account is drawn down and the longer it has to accumulate wealth.
Don’t Ignore charity or non-person beneficiaries
If the IRA you are inheriting has multiple beneficiaries that include charities or other entities other than a person there are strict payout procedures and time lines to follow. These types of beneficiaries must be paid their inheritance by no later than September 30, of year after the owner’s death according to the IRS. The penalty for not complying with the payout is that all of the beneficiaries are excluded from taking withdrawals over their life time in accordance with Table 1 mentioned above. The account must be liquidated (emptied) within 5 years if the original owner of the account died before taking RMDs. If he died after taking his first RMD beneficiaries must take RMDs based on the deceased’s life expectancy tables.
There are also rules to follow if a trust is a beneficiary. You should talk with your attorney, financial planner, or IRA custodian to ensure you follow all of the rules. A copy of the trust must be sent to the custodian of the IRA by October 31 of the following year after the owner died. If the owner died March 1, 2015 the trust document must be sent to the IRA custodian by October 30 of 2016. The penalty for not doing this is the same as mentioned above for charities.
Disclaiming Your Interest
For tax planning and other purposes some choose to disclaim their inherited interest. According to Fidelity Investments, “If you decline to accept all or part of the IRA assets you are entitled to, they will pass to the other eligible beneficiaries. If no other beneficiaries exist, the assets will pass in accordance with the IRA provider’s contractual defaults. For example, with a Fidelity IRA the assets will pass to the original IRA owner’s surviving spouse and, if none, to the estate. A decision to disclaim IRA assets must be made within nine months of the original IRA owner’s death and before you take possession of the assets. This is an irrevocable decision. Therefore, as with any tax-related matter, it’s critical that you consult a tax adviser or attorney before disclaiming IRA assets.”
Most custodians of inherited IRAs offer counseling and will help you set up your inherited IRA account. You can elect to establish your IRA at any custodian that you choose. Don’t hesitate to contact them for guidance when setting up your inherited IRA. Most large brokerage houses also will set up an account for you and they provide guidance on these matters, talk with their specialists if you have any questions about your inheritance. Here are two of the largest IRA Custodians that can provide guidance.
- Fidelity inheritor services specialist: 800-544-0003, Inherited IRA Guidance 
- Vanguard: 877-662-7447, Inherited IRA Guidance 
The problem with converting your easily managed TSP fund to an IRA is finding suitable fund replacements that will replicate the TSP funds that we now have available. The final article in this series, part 3, will discuss indexed mutual fund and ETF alternatives to the various TSP funds.
Another consideration is can you do it on your own or do you need a financial adviser to help you along the way. Read my article titled Have You Considered Hiring a Financial Adviser  to help you decide what road to take.
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