by Bill Harris, CFP, RMA
You’ve probably heard of this saying before, but it was probably in the setting of a detective show on TV!
Modus operandi is defined as a method of procedure. Of the three proactive options (Inherited IRA, Spousal Rollover, or Do-Nothing), which is the best modus operandi? It depends. It all comes down to the goals and circumstances surrounding the surviving spouse. However, there is a general rule of thumb that will give you the right answer virtually every time. Age is the driving factor behind most spousal beneficiary decisions. Here are explanations of what occurs if you are below or above age 59½.
Below Age 59½
If you are a surviving spouse beneficiary and you are under the age of 59½ at the time you inherit an IRA from your spouse; then, the correct planning move is to establish an inherited IRA. This will allow you to access funds without paying penalties. Those funds should continue to be kept in an inherited IRA until you turn 59½. Once you reach that age threshold, you should execute a spousal rollover. The most common exception to this rule is when the deceased spouse was over age 72, RMDs had begun, and the surviving spouse knows with absolute certainty that she will not need access to those funds until after she reaches age 59½.
Above Age 59½
If you are over age 59½, execute a spousal rollover immediately. The most typical exception to this rule is when the surviving spouse is older than the deceased spouse (but not yet age 72), and the surviving spouse wants to delay RMDs for as long as possible. RMDs would be based on the younger deceased spouse, so fewer funds would need to be distributed annually, lower taxes would be due, and more of the taxes would be deferred.
Why is this strategy correct most of the time?
There is never a downside to using it. It allows a surviving spouse maximum flexibility without being hindered in any way. Some might argue that by remaining a beneficiary of an inherited IRA, it could lead to the surviving spouse having to take RMDs prematurely, that is, before she turns 72. However, that is unlikely. A surviving spouse generally does not have to start taking distributions until her deceased spouse would have reached age 72. Most spouses are relatively close in age. As a result, it’s an unusual scenario that would force a spouse to choose between maintaining a penalty-free inherited IRA and moving the inherited IRA funds to her own IRA to avoid RMDs.
An Example of a Modus Operandi
Sometimes seeing an example can help clarify a concept. Let’s look at one:
Lisa (age 50) and Peter (age 55) are a married couple. As happens in so many marriages, Lisa is named as the sole beneficiary of Peter’s IRA. When Peter dies, Lisa should follow the modus operandi mentioned above. She should set up an inherited IRA and remain a beneficiary until she reaches age 59½, then execute a spousal rollover. That will allow her to withdraw money if needed from the IRA without paying the 10% early withdrawal penalty, even though she is not 59½ yet.
Does Lisa have the option of splitting the inherited spousal IRA if she chooses? Yes!
When she inherits Peter’s IRA at age 50, she may be debating between keeping it as an inherited IRA or transferring it to her own traditional IRA.
She can split the difference.
She can roll over as much as she’d like to her own IRA, and she can roll over more at different times in the future. However, note that once an amount is rolled over to her own IRA, that move is permanent. That amount can no longer be treated as inherited, and it would be subject to the 10% penalty if she took a distribution prior to age 59½.
Furthermore, since Peter and Lisa are relatively close in age (just five years’ difference), with proper planning and execution, there will never be a time when Lisa would be forced to take RMDs from the inherited account.
First of all, since Peter was just 55 when she initially inherited the account, he was much younger than the critical RMD age of 72. (On the other hand, had Peter been 72, Lisa would be required to take RMDs from her inherited IRA.)
However, in this case, by the time Lisa hits 59½, Peter would still only have been 64½, had he lived. Therefore, no RMDs would be required at that time, either.
In fact, by the time Peter would have been 72 (which would trigger RMDs for the inherited IRA), Lisa would already be 67. If she had followed the modus operandi in its entirety, she should already have made a spousal rollover of the inherited funds into her own IRA (at age 59½).
Following that spousal rollover, as noted earlier, the funds would be treated as if they had always been in Lisa’s IRA account, allowing her to continue to delay RMDs until she turns 72.
As mentioned earlier, protecting the next generation of beneficiaries is also an integral part of estate planning. It is important for a surviving spouse, as a spousal beneficiary of an IRA, to name her own beneficiaries immediately. A beneficiary can be almost anything (an individual, an estate, a charity, or a trust). A surviving spouse has total freedom when selecting beneficiaries.
As mentioned earlier, but worth repeating, three types of beneficiaries can be named:
- Eligible designated beneficiaries.
- Non-eligible designated beneficiaries.
- Non-designated beneficiaries.
Whether eligible or non-eligible, must be living persons whose names are on the IRA’s beneficiary form. Eligible designated beneficiaries have the advantage of being able to use their own age and life expectancy when calculating mandatory distributions, possibly stretching those distributions out over many years. Non-eligible designated beneficiary or beneficiaries (non-spouses and certain trusts), the entire IRA balance must be distributed to the beneficiaries by the end of the tenth year after the death of the IRA owner.
Non-Designated Beneficiaries, on the other hand, will have to empty an IRA account over five years, following the 5-year distribution rule.
Let’s look at an example where, because there was no designated beneficiary, distributions could not be stretched:
Jason and Steve were one of the first same-sex couples to marry. They focused on doing their estate planning right away. They set one another up as the spousal beneficiary. Jason died unexpectedly at 57, leaving his IRA to his spouse Steve, age 54.
Steve did nothing with the IRA.
Over time, it would default to a spousal IRA, which allows the spouse to treat the deceased spouse’s IRA as his own. This option is seldom used in the real world. However, it has the same tax consequences as a spouse completing a spousal rollover.
Steve died seven years later, at age 61, but had not named any beneficiaries. In the absence of beneficiaries, the default beneficiary becomes Steve’s estate (unless the custodian’s IRA agreement had default language spelling out otherwise).
Steve’s estate is a non-designated beneficiary—one with no life expectancy. There is only one distribution option for Steve’s beneficiaries: the 5-year payout rule.
Under the 5-year rule, the entire IRA balance would have to be distributed to the beneficiaries of the estate by the end of the fifth year following the year of the surviving spouse’s death.
No RMDs need to be made for years one through four after Steve’s death. The estate can take as much or as little as they want in those years, and they will pay tax on the amount withdrawn.
However, in year five, the estate will have to withdraw the total remaining account balance. Failure to drain what is left in the account will result in a 50% tax penalty on the entire remaining account balance.
If the IRA balance is relatively small, a 5-year payout may not be a bad option for the beneficiaries. However, if the IRA balance is large, then a huge tax bill is generated on the final distribution. An alternative strategy could be to take a smaller distribution each year. Obviously, an analysis of the tax impact needs to be conducted. So a plan that would net the most could be developed and adhered to.
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.
You can find the full book here.