THE SEPARATE ACCOUNT RULE: HOW IT AFFECTS IRAS

 

 

by Bradford N. Dewan, J.D., MBA

Many questions are raised by clients and advisors regarding the distribution rules and issues that arise after an IRA owner’s death. One of the questions most frequently asked is how the required minimum distribution (“RMD”) amount is determined for each beneficiary when there is more than one primary beneficiary of the IRA.

If an IRA is inherited by more than one beneficiary, the general rule is that the RMDs may be stretched out over a period no longer than the single life expectancy of the oldest beneficiary. However, if certain requirements are met, each beneficiary may be allowed to receive his or her share of the IRA funds over his or her own single life expectancy. However, to do so, the decedent’s IRA would have to be split into a separate inherited IRA for each beneficiary.

For example: Charles dies at age 55. His brother, Terry (age 60) and his niece, Betty (age 25) are co-primary beneficiaries of Charles’ IRA. Terry and Betty may each choose to receive his or her share of the IRA funds by the end of the fifth year following the year Charles died, or they each may choose to stretch his or her share of the IRA funds over a life expectancy. However, to satisfy the “life expectancy rule,” distributions must commence on or before the end of the calendar year immediately following the calendar year in which the IRA owner died. Then, applying the general rule for calculating the life expectancy payments, the RMDs for both of the beneficiaries, Terry and Betty, would be based solely on Terry’s single life expectancy since he is the elder of the two beneficiaries.

However, if the IRA is split into separate inherited IRA accounts for Terry and Betty by the end of the calendar year after the calendar year in which the IRA owner died, the RMDs for Terry’s inherited IRA will be based on Terry’s single life expectancy and the RMDs for Betty’s inherited IRA will be based on Betty’s single life expectancy. This will result in obtaining the maximum stretch-out benefits for Betty. Under the Single Life Table, Terry’s life expectancy is 25.2 years, but under this table, Betty’s life expectancy is 58.2 years. Consequently, Betty will have the opportunity to realize tax deferred growth of the investments in her inherited IRA for thirty-three (33) more years than if she had to use Terry’s single life expectancy.

Thus, to use each beneficiary’s single life expectancy to determine the RMDs for his or her respective share, separate inherited IRAs must be established (and RMDs taken) by December 31 of the year following the year of the IRA owner’s death. For example, if Charles, from the previous example, died in 2014, and the IRA was transferred to a single inherited IRA by December 31, 2015, the RMD amounts for both Terry’s share and Betty’s share (to be distributed by December 31, 2015) would be based on Terry’s single life expectancy, because Terry is the beneficiary with the shorter life expectancy. But if both Terry and Betty formed and funded their respective inherited IRA by December 31, 2015 (and received their respective RMD by December 31, 2015), then Terry and, most importantly, Betty, would each be able to calculate his or her respective RMDs for 2015, and each succeeding year, based on his or her own life expectancy.

In conclusion, being aware and taking advantage of the “separate account rule” can result in the youngest IRA beneficiary realizing a significant financial benefit by being able to apply his or her own longer life expectancy, rather than that of the oldest beneficiary, in calculating the RMDs.

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