Irrevocable Mistakes Can Decimate an Inherited IRA

Posted: May 09, 2006 6:25 PM

Not long ago, a son who had inherited his father's Individual Retirement Account wisely decided that he wanted to preserve his windfall. He concluded that the best place for this money was in his own IRA, so he rolled the money into a new account.

What I'm wondering at this point is whether you spotted the son's disastrous mistake. No one - including the Internal Revenue Service, who turned out to be this tale's bad guy - could argue that the son wasn't well-intentioned. Keeping an IRA alive, instead of blowing the cash and paying the tax, is a very smart idea.

But in this story, the heir may as well have been the prodigal son who blew his inheritance. At least spending the cash on a monster plasma TV, a summer in the French Riviera or a remodeled kitchen would have been a ton more fun.

What the son failed to realize was that he couldn't take his dad's IRA and transfer the cash into his own IRA. The IRS regulations stipulate that only a spouse can perform this sort of rollover. So for doing something that seems imminently reasonable, the son was severely punished: He paid income tax on this inheritance and his IRA was dissolved.

What should our hapless victim have done?

He needed to keep his dad's name on the account and add his own name and Social Security number. Here's how the revised title might appear: Michael McCormack IRA (deceased April 2, 2006), F/B/O (for the benefit of) Patrick McCormack, beneficiary.

How could this poor guy know about this seemingly arcane IRS rule? Good question. You could also ask why the financial institution where he established the account didn't grab his paperwork or maybe even slide tackle him before he committed this irrevocable mistake. Surely, a brokerage firm, bank or mutual fund company should know this stuff. In this case, a sharp-eyed stockbroker in Jacksonville, Fla., who was reviewing his new client's holdings discovered the error.

What's really scary about this story is how often IRAs are decimated because they have been manhandled by their owners, heirs, financial institutions or by all parties involved. These muggings happen daily, and the crisis is only going to worsen as cash continues to flow into IRAs. By one estimate, Americans have $3.5 trillion in IRAs, and far more than that will be transferred from 401(k)s and other workplace plans into these accounts.

To keep your own IRA or inherited IRA from imploding, you need to be especially vigilant during the following IRA milestones:

  • When retirement assets are moved from a workplace plan into an IRA rollover.

  • When required minimum distributions start after an investor reaches age 70 1/2.

  • When loved ones inherit an IRA.

    Some of you might suspect that I'm being a bit hysterical, but once an IRA mistake occurs, it often can't be stuffed back into the box. That's why some advisers call them Internal Revenue Accounts.

    But there are ways to protect your IRA, stretch its value beyond your lifetime and insulate it from unnecessary taxes.

    Many people spend a lifetime building sizable IRAs only to have them land in the laps of their grown children, who fritter them away. The children pay federal and state taxes on the inheritance and spend the money; soon only the old account statements can prove that the accounts ever existed.

    If you don't expect to drain your IRAs before you die, it's crucial to explain to your kids that your retirement accounts will be infinitely more valuable if they don't pilfer them but instead make them last through their own lifetimes.

    Someone who inherits an IRA, however, can't keep it in a hermetically sealed capsule. Uncle Sam expects heirs to take required minimum distributions, which are based on the recipient's age and the size of the account. The IRS maintains tables that can help people pinpoint how much money they must siphon annually from an account.

    No doubt the best way to capture the attention of future beneficiaries is to appeal to their greedy side. If they knew how much an IRA could be worth over their lifetimes, they might be less inclined to snatch the money up front.

    To illustrate, I'll use an example from Ed Slott, a CPA from Rockville Centre, N.Y., who is regarded as one of the nation's leading IRA experts.

    Suppose, he suggests, that a 57-year-old son inherits from his mother an IRA that's worth $219,000. The IRS says that the son would be expected to live another 27 years. The withdrawal clock starts the year after his mother's death, when the IRS will require that the son take out $7,907. The next year, he must withdraw $8,540.

    What's eye-catching about this scenario is how much money the son would ultimately capture from this IRA by draining it slowly. Assuming the $219,000 account generates an 8 percent return, the son would pocket $1,020,366 during the 27-year period. In contrast, if the son cashed in his $219,000 inheritance, he would have spent a large portion of it paying federal and state income taxes.

    Handing off an IRA to a grandchild would generate even more dramatic results. Suppose, for instance, that a 1-year-old granddaughter inherits a $100,000 account from her grandfather. The IRS will expect her to withdraw the cash over the next 81.6 years, Slott says. If the account earns 8 percent in annual returns, the girl will ultimately withdraw $8.1 million.

    Now that's some chunk of change.