Inherited IRAs can be defused of any tax bomb

Money Talk

Your Money

March 28, 2004|By MATT LUBANKO

I'VE BEEN told that it's extermely important for adult children to pay close attention to basic paperwork when they inherit an IRA from a parent. Why must they be so careful?

- B.T., Baltimore

In the best cases, IRAs pass seamlessly from generation to generation.

But snafus occur sometimes and, when they do, it's often because of a failure to correctly "retitle" the existing account.

To see what can go wrong, and why retitling is so important, let's review a hypothetical case. Let's say an accountholder died in March 2004, leaving a $100,000 IRA to his daughter.

FOR THE RECORD - The Money Talk column published Sunday in the Your Money section of Business incorrectly stated that a death benefit distribution from an Individual Retirement Account could be subject to a premature withdrawal penalty of 10 percent. In fact, a distribution from an IRA due to the owner's death would be exempt from such penalties.

The daughter, perhaps unaware of the tax laws, liquidates the account and thus is stuck with a tax on $100,000 of income; withdrawals from IRAs are generally taxed as regular income. If she was under age 59 1/2 , she could also be slapped with a premature withdrawal penalty of 10 percent.

This tax bomb could have been defused by correctly retitling the IRA just after the father died.

The retitling would read something like this: "T. Rowe Price Trust Co., custodian for the traditional IRA of Joseph Jones (DCD), Josephine Jones (BENE)," followed by the home address of Josephine Jones.

The DCD stands for "deceased." The BENE stands for "beneficiary."

And, while each company might have its own procedure, "somewhere the name of the deceased owner has to be in the account, and somewhere the name of the beneficiary has to be in the account. And each must be properly designated," said Christine Fahlund, senior financial planner at T. Rowe Price in Baltimore.

The beneficiary, under the tax laws, would still be required to take required minimum distributions, or RMDs, from the IRA she inherited from her father. And those withdrawals would be taxed as regular income.

But the RMDs could be stretched out over several decades, probably in increments of a few thousand dollars a year, Fahlund said.

What can you tell me about transfer-on-death accounts at brokerage houses? What are some of the drawbacks of choosing this route to transfer bequeathed property?

- A.P., Wethersfield, Conn.

Transfer-on-death accounts eliminate much of the friction in passing on property to heirs. They're easy: The paperwork is fairly simple. They're cheap: There's little need to have a lawyer present when making these arrangements. They're quick: Soon after you die, your heir or heirs will receive the stocks, bonds, mutual funds or cash you leave behind.

This simplified approach to estate planning, if properly executed, can eliminate costly and time-consuming middlemen such as lawyers and probate courts.

Much like beneficiary forms with life insurance policies, 401(k) plans, or IRAs, plans documented in a TOD account can override any wishes spelled out in a will or trust agreement.

With the potential to sign away so much power with such ease, TOD accounts should be seen as just one part of a carefully conceived estate plan, said Barry Zischang, a senior vice president and wealth strategist with Advest Group in Westport, Conn.

But there are some things TOD accounts can't do. Zischang says they don't shelter money from state or federal estate taxes, nor do they magically place money out of reach of creditors or tax collectors. "I have heard of creditors going after an heir to a TOD account two years after the date of death," Zischang said.

So spare your heirs from an unpleasant posthumous surprise. Understand the power and dangers of TOD accounts before you open one.

Matthew Lubanko is a financial columnist for the Hartford Courant, a Tribune Publishing newspaper. E-mail him at yourmoney@tribune.com.

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