by William Harris, RMA, CFP
Introduction: Why I Want You to Have This Knowledge
If you are reading this book, chances are your spouse has passed. I want to take a moment to honor the memory of your life together and give you my sincere condolences.
Over my thirty years of experience in the financial advising industry, my heart has always gone out to our clients that have been widowed.
It is such a hard time of unimaginable pain and adjustment, and the last thing you need to worry about is sorting out all the financials.
Shifting the firm’s focus to specializing in widows didn’t happen overnight and evolved out of several events that led us to understand that we had something special to offer to widows that weren’t found elsewhere.
There was one seminal moment that started us down this path, and it began when a woman – we’ll call her Elizabeth – came to our firm in a state of emotional and financial distress. She was only in her 60s when her spouse ‘Jim’ had passed away suddenly a month before.
Jim had “handled” every aspect of their financial life and had placed all their assets in his name. Following his death, all their assets were temporarily frozen because Jim had accumulated lots of credit card debt and had secretly been withdrawing from an equity line of credit on their home.
Elizabeth was not aware of any of this, and she was struggling to cope with her tragic loss and make sense of their disastrous financial situation. As far as financials go, it was one of the worst situations I had ever encountered, and my heart went out to her. I wanted to help rectify her financial conundrum, of course, but I realized that to be of value to someone in her situation, much more than financial support was needed. She needed a partner to help her financially and emotionally, as the person she had relied on most in the world was gone.
Elizabeth had very little credit history of her own. She had already sold a car to pay for Jim’s funeral and was at a loss as to where to begin to repair the damage.
Delivering the news to someone coping with the loss of a spouse that she was close to broke when she was mere inches from retirement was devastating. I’ll never forget the sting of delivering that message.
From that moment on, we knew we needed to help people in her situation both rebuild their finances and their lives. We shifted our primary aim and dedicated ourselves and our practice to helping widows get back on their feet, rise up and navigate their path forward, all while helping them feel empowered and even – eventually - hopeful.
In addition to widows, we also decided to help couples avoid the same issues Elizabeth faced and dedicated ourselves to couple education and prevention so they wouldn’t have to cope with financial surprises and difficulties after one of them passes.
The statistics vary from year to year, with the average age of widowhood at about age 59. For most women, that means 25 to 30 more years yet to be lived—and financed without the help of a spouse. (Possibly more as life expectancies continue to rise.) Because of these sad facts, this scenario must be addressed in every couple’s financial plan, preferably before the loss of a spouse.
Note: Here is my upfront disclaimer on the use of he and she, his and her. They are interchangeable for this guide, as are the terms widow and widower. However, as more men predecease their spouses than do women, we have most often used the terms she, her, and widow.
In December 2019, the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act) was signed into law. This book has been published to reflect two major SECURE Act changes and their impact on widows inheriting a spouse’s IRA. Those changes are (1) limiting the use of a popular strategy called Stretch IRAs, and (2) raising the onset of Required Minimum Distributions (RMDs) from age 70½ to 72.
The SECURE Act’s changes to the laws governing retirement accounts—both in terms of sheer volume and impact—are considered by many experts to be the most significant changes since the passing of the Pension Protection Act of 2006.
As of the publishing of this book, the Secure Act is in its infancy. Interpretations of Congressional acts take years to sort out. We are still looking for IRS guidance for much of what has been given via the SECURE Act. Guidance from the IRS and, unfortunately, precedents resulting from tax court cases are what will ultimately shape the impact of the SECURE Act.
We will update this book as events unfold. If you would like updates and other helpful tips, sign up for the WH Cornerstone newsletter at whcornerstone.com and follow our blog at whcornerstone.com/blog
The First Year
The first year after the death of your spouse will be more tactical than strategic. While I realize this sounds somewhat harsh, it is truly a time of “triage.” The goal is to assess the situation and stabilize what needs to get done immediately, as well as assign degrees of urgency to various aspects of the widow’s financial life.
Over the many years of working with widows, I have found more often than not that an estate will often include an IRA. If you are a beneficiary of an IRA, you may find yourself with many questions and concerns. Let me answer one of those questions right here.
The IRA rules are different for spousal beneficiaries than they are for a non-spouse or trust beneficiaries. To get the most significant benefit from the IRA, we recommend arming yourself with a working knowledge of the Dos and Don’ts. And work with a competent, educated financial advisor to keep more of your assets and lose less to taxes and unnecessary fees.
In our experience, every widow’s case is different. But there are common needs and questions. Starting with, “Will I be financially okay?” and, “Where will I get money, and how long will it last?” Our goal with this book is simple: to provide a surviving spouse with a guide for handling an inherited IRA.
Why did we choose to write this book now? As of 2018, approximately $28 trillion resides in retirement assets in the United States (source: Investment Company Institute®). That’s trillion with a “T”! That makes inheriting a deceased spouse’s IRA, at some point, almost a universal event.
But here’s the scary part. How that IRA is handled can make or break the post-widowhood plan. We receive questions on this subject regularly and are disheartened by the misinformation we see shared on the topic in the mainstream. Many times, widows have come to us after having been served with “helpful advice” from friends, family, the big discount brokerage firms, and wire-house call centers. Often, this advice is factually incorrect. Unfortunately, having incorrect information at this stage of life can be devastating.
While there are many details to tackle in a post-widowhood plan, structuring the inherited IRA is the most critical, and I’d say it is the first job to be taken care of. I can’t say this too many times. While the focus of this book is, “What to do with an inherited IRA,” we do want to acknowledge the extreme difficulty this situation has put you in.
No one plans on becoming a widow, nor do they foresee the impact that widowhood will have on every aspect of life. That is why it is so important for us to write this guide. On a personal note, we’d also like to pass on some simple advice: please avoid making big decisions until after the first year of your loss. While grieving is difficult and different for everyone, we’d suggest avoiding big decisions for at least a year.
In the first year, you’ll be in a fog, and sometimes it will feel like all the days run together. Many of our clients have confided in us that they can’t even remember most of the decisions they made immediately following their spouse’s death. It’s a vulnerable time. You may feel pressure from others to make important decisions. But please try to avoid these situations at all costs.
Always remember to use your professional advisers. They will have information that will help guide your decisions and also inform you on what has and has not been put into place in the event you became a widow. While I have a vested interest in telling you that it doesn’t lessen the invaluable information they can provide. This holds true if you were not the one who typically handled the financial affairs of the household. Please get professional help. It’s a worthwhile investment, and the peace of mind it will provide you is priceless.
The Day “Widow Whirl” Changed My Life
Before we dive right in, I’d like to share a little bit about my back history. My work with widows and IRAs had a serendipitous beginning. In the early 1990s, I was working at State Street Global Advisors, a spinoff of State Street Bank and Trust. I was in an investment operations job dealing with thousands of retirement plan participants.
We had everything conceivable from retirement plan structures, such as Keogh plans, 401(k) plans, profit-sharing plans, defined-contribution, and defined-benefit plans. Our unit routinely received an overwhelming number of distribution requests from widowed beneficiaries. With the number of requests that came in, we were continually researching what the law allowed or forbade for these requests. It was then that I realized that big institutions were not providing the necessary personalized advice.
Frankly, they are still not offering tailored advice. The frequent disclaimer you see that states, “Always consult with a tax professional,” is a constant reminder the advice side of the business has a long way to go. At that same time, I was completing my MBA at Suffolk University in Boston. One of my classes was on portfolio management. I was presented with a case study that would change my career. It was called “Widow Whirl.”
In this case, a widow named Widow Whirl had two sons. The goal of the project was to design three portfolios:
• One for income for the “Widow Whirl”.
• And two separate portfolios that would be appropriate for her two children.
Each of her children had different needs that were to be considered when creating the portfolios. That case study truly opened my eyes to the world of financial planning. After working on the Widow Whirl case and finishing my master’s degree, I quit my job at State Street Global Advisors and started what, today, is called WH Cornerstone Investments.
WH Cornerstone’s Compassion for Widows
From day one, WH Cornerstone Investments has had a history of working with widows. Soon after I started my firm, I received a call from a dear friend. I can still remember his words; he said, “My Dad died. I need you to go help my Mom.” Where the Widow Whirl case had been an academic exercise consisting of papers and numbers, this call had hit home in a personal way. It was real now.
Being in a business that deals with numbers and facts and figures, it’s easy to lose focus. Many times, the “Big” financial institutions can quickly lose touch with the fact that account balances represent real people’s lives. And, in many cases, it’s a summary of their entire life. Those balances represent years of hard work, saving, and sacrifices, that took place in a real-life family. Big institutions tend to miss that fact.
Our firm celebrates it. We realize our actions will impact a family, not for a few years to come but for generations. In many cases, the education and well-being of the widow, her children—plus their children and their children’s children (that is, the widow’s great-grandchildren)—may all be affected. At WH Cornerstone, we never forget this.
We have written—and will continue writing—on the best practices for widows when it comes to dealing with their finances. Look at this book as your guide on what you should do the majority of the time; when you inherit your spouse’s IRA. Every planning situation is unique and reflects endless combinations of goals and objectives. The overwhelming majority of married couples with IRAs (and other similar accounts) will name their spouse as their primary beneficiary as part of their estate plans. While there are always exceptions to a rule, knowing the basic rules that apply when a spouse inherits an IRA is critical for just about every married couple.
As you will see in the pages ahead, the rules are not simple; they are complex and confusing. In fact, some special rules exist which only apply when it is a spouse who inherits an IRA. Those are the rules that can significantly complicate your already delicate situation.
Our wish for you is that by the time you have finished this book, you will be uplifted and encouraged to see there are solutions that are obtainable and there are answers to your questions. Please be patient with yourself and know we are here to help you, whenever and however you need us. You are in our thoughts.
Chapter 1 - IRA Terms and Concepts
IRAs are a common topic among investors. Many people go through life talking about—and contributing to—IRAs and other tax-sheltered assets. But most never really delve deeply into how they work. Others get by with knowing “enough,” and then again, other investors are virtual experts.
Wherever you are along that continuum, we want the rest of this guide to be valuable to you. And for that to be true, this guide must be easily understood. Therefore, we have provided a short “primer” on IRAs that explains some of the foundational concepts. Whether you read about them now—in advance—or only refer back when something seems unclear, use this resource as a cheat sheet of sorts to help keep the terms at your fingertips.
Also, terms, concepts, and rules may appear and reappear in this book. Redundancy is never a bad thing when you are learning something new. We’ll take it in bite-size pieces. So, let’s jump right in, and as they say, “How do you eat an elephant? You eat it one bite at a time.”
While technically called Individual Retirement Arrangements, the vast majority of people refer to IRAs as Individual Retirement Accounts. They are also called “traditional IRAs.” Contributions to traditional IRAs are typically made with pre-tax dollars. That means no taxes were paid when those dollars were earned, so the IRS will collect taxes when funds are taken out of traditional IRAs. The traditional IRA also has two siblings, a Roth IRA and a nondeductible IRA.
Roth IRAs are a type of tax-advantaged retirement savings account. Contributions aren’t deductible, but qualified distributions (that is, withdrawals) on contributions and earnings are tax-free. Anyone with earned income below a specific limit can contribute to a Roth.
Contributions to a nondeductible IRA are made with after-tax dollars. You can’t deduct such contributions from your income taxes as you would with a traditional IRA. However, your nondeductible contributions will still grow tax-deferred.
Many people turn to these options because their income is higher than what the IRS allows if they want to make tax-deductible contributions to a traditional IRA. Since there was no deduction for the nondeductible IRA, distributions will only be partially taxed via the pro-rata rule. If nondeductible contributions were ever made to the IRA, then not all amounts distributed would be taxable.
The cost basis of an IRA is the sum of any nondeductible contributions, less any distributions of nondeductible contributions. Form 8606, Nondeductible IRAs, is used to track the basis of a traditional IRA. This form should be filed every year that nondeductible contributions are made to a traditional IRA.
When after-tax dollars or nondeductible dollars enter a traditional IRA, distributions from that account are a mix of both pre-tax and after-tax dollars. For example, if a taxpayer had an IRA balance of $100,000, with $10,000 in after-tax contributions, the after-tax portion would represent 10% of the total account balance. As a result, any distribution would consist of 10% of after-tax dollars and 90% of pre-tax dollars. For a withdrawal of $10,000, the after-tax (non-taxable) portion would be $1,000 and the pre-tax (taxable) portion would be $9,000. The IRA account would then have a total balance of $90,000, with $9,000 in after-tax contribution (still 10% of the total account value).
Payment of Taxes on IRA Distributions
While the U.S. Government gives you the opportunity—and incentive—to benefit from tax-sheltered assets to prepare for retirement; eventually, it wants to get its taxes from those earnings. It does so when you withdraw funds from those accounts, under terms determined by specific rules. Withdrawals such as these are called “distributions.”
Critical Ages Related to IRAs
Two ages, 59½ and 72, are pivotal when it comes to IRA distributions. In most cases, any funds you withdraw from your IRA before you reach age 59½ will not only be taxed at your present rate of taxation but will also incur a 10% penalty for “early withdrawal.”
At age 72, you will be required to start making withdrawals, called Required Minimum Distributions, or RMDs. You can contribute to an IRA forever, regardless of age, as long as you have earned income. (The same rule applies to Roth IRAs.)
Under the new SECURE Act, you now have a money-in-money-out possibility. You can make contributions well beyond the age at which you may be forced to take distributions.
Required Minimum Distributions (RMDs)
These provide the IRS with the mechanism to start collecting taxes on your traditional IRA. They are made according to a formula defined by the IRS and based on your life expectancy. RMDs are calculated using two life expectancy tables issued by the IRS. Penalties will be incurred beyond the taxes due if you fail to withdraw the minimum distribution required each year.
Required Beginning Date (RBD)
This is the date by which an IRA owner must have taken the first Required Minimum Distribution (RMD). For the first RMD, the date is no later than April 1 of the year following the year the owner reaches age 72. For later years, RMDs must be taken by December 31 of the same year.
Importance of Beneficiaries
The ability to designate beneficiaries to an IRA provides control over what happens to the funds in an IRA when its owner dies. The importance of keeping beneficiaries updated as life changes the nature of relationships cannot be overstated. The absence of a viable beneficiary puts ownership in the hands of a probate court or a directive in the custodian’s IRA agreement.
Designated Beneficiaries (Eligible and Non-Eligible)
Designated beneficiaries can be eligible and non-eligible. Eligible designated beneficiaries (EDBs) are individuals who are spouses of account holders, disabled or chronically ill individuals, an individual not more than ten years younger than the decedent, minor children of decedents, or “See-Through” trusts.
Non-eligible designated beneficiaries (non-EDBs) are any individuals who qualify as a designated beneficiary but who are not on the list of eligible designated beneficiaries.
These are non-person entities such as certain trusts and charities.
Five-Year Distribution Rule
This rule affects the timing requirement for distributing the proceeds of an IRA to a non-designated beneficiary. If an IRA goes to a non-designated beneficiary, the entire IRA balance must be distributed to the beneficiaries of the estate by the end of the fifth year after the death of the IRA owner. No distributions are required for years one through four after the owner’s death. The beneficiaries can take as much or as little as they want in those years, on which they will pay tax. A final required distribution, equal to the total remaining account balance, is required in year five. Failure to drain the account at the end of year five will result in a 50% tax penalty on the entire remaining account balance.
Ten-Year Distribution Rule
This rule affects the timing requirement for distributing the proceeds of an IRA to a non-eligible designated beneficiary. If an IRA goes to a non-eligible designated beneficiary or beneficiaries, the entire IRA balance must be distributed to the beneficiaries by the end of the tenth year after the death of the IRA owner. (Eligible Designated Beneficiaries have a different set of rules.)
No distributions are required for years one through nine after the owner’s death. The beneficiaries can take as much or as little as they want in those years, on which they will pay income tax. A final required distribution, equal to the total remaining account balance, is required in year ten. Failure to drain the account at the end of year ten will result in a 50% tax penalty on the entire remaining account balance.
Stretch IRA Strategy
A stretch IRA is a strategy and not the name of a type of IRA. Before the SECURE Act, it allowed younger beneficiaries to “stretch-out” Required Minimum Distributions (RMDs) based on their longer remaining life expectancy. The stretch IRA kept RMDs and taxes low. Therefore, the balance in the inherited IRA would continue growing tax-deferred as a form of inter-generational wealth transfer. The SECURE Act, for the most part, has eliminated the stretch IRA.
IRS Life Expectancy Tables
The value of your Required Minimum Distributions (RMDs) is based on an IRS life expectancy table. In general, you would divide the balance in the IRA at the end of the prior year by a factor from the correct table. You can find the corresponding tables at the IRS website and elsewhere.
Sole Spouse Beneficiary
This occurs when the spouse of the IRA owner is the only named and legal beneficiary of the IRA, and the proceeds of the IRA are not shared with any other beneficiaries. It is a requirement for being able to apply the special rules for spousal beneficiaries, although some ways exist to rectify the situation when more than one beneficiary is named.
The gap period runs from the date of the death of the IRA owner to September 30 of the year following the year in which the owner dies. It is a period in which considerable planning activity can be taken to benefit IRA beneficiaries strategically.
Splitting an IRA
Where there is more than one beneficiary, an IRA can be split into a separate IRA for each beneficiary. Splitting an IRA must be completed by December 31 of the year following the year in which the IRA owner dies. Splitting is most critical when one beneficiary is a non-designated beneficiary, such as a charitable organization.
A primary beneficiary can use a disclaimer to waive her rights of possession of an IRA, as long as the action is completed within nine months of the date of the death of the IRA owner. By refusing to accept the property, the property then passes to the contingent beneficiary. It may also provide a way to transfer assets to the next line of beneficiaries.
HUD administers a reverse mortgage program that offers a type of home loan available to homeowners age 62 and older. These mortgages can be used to complement a retirement plan by creating liquidity out of an illiquid asset—a house.
Like a traditional mortgage, a reverse mortgage uses the home as security for the loan, but borrowers don’t make monthly mortgage payments. (They must, however, pay property taxes, homeowner’s insurance, HOA fees, and maintenance.) The loan comes due when the borrower leaves the home and is usually paid off by selling the home. As a “non-recourse” loan, the borrower (or estate) is not responsible for any repayment shortfalls.
Summary of Key Terms
While this seems like a lot of information all at once and can feel overwhelming, rest assured that this is the foundation of what we will share with you throughout the book. Every example we share will be explained in an easily understandable way. Please feel free to flip back and forth as you read the book, so you’ll feel comfortable with the terminology.
The above article originally appeared as a chapter in Inheriting Your Spouse's IRA and is reprinted with permission from the author Bill Harris, RMA®, CFP®. No parts of this article may be reproduced without correct attribution to the author of this book.
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