IRA Rollovers, Transfers, and Cashouts . . . Oh My!

As estate planning attorneys, one of our jobs is to advise clients on the handling of assets that pass outside of their living trusts. Individual Retirement Accounts, also known as “IRAs,” are a common retirement savings tool that many clients have in their portfolios. We often get questions about how these accounts pass to beneficiaries after the death of the account holder.

One important thing to remember is that traditional IRAs—we are not discussing the passing or transfer of Roth IRAs in this article, so any reference to “IRA” is to a traditional IRA unless otherwise indicated—are tax-deferred savings tools, which means the taxes are not paid until a distribution is taken. Therefore, if there are funds remaining in an IRA at an account holder’s death, someone will have to pay the taxes. How and when those taxes are paid depends on what happens to the IRA at the death of the account holder. Therefore, careful coordination with your team (financial advisor, attorney, and accountant) is recommended when planning with IRAs. There are generally three options for the handling of a traditional IRA at death. Each of these applies to different circumstances.

IRA Rollover

Although you will very often hear about “IRA rollovers,” this description is often used improperly. A rollover is a very specific type of transfer, typically only available to certain beneficiaries, depending on their relationship with the accountholder. When an IRA account holder dies, their IRA assets may be “rolled over” into an IRA for the beneficiary. Note that spouses who inherit an IRA from their deceased spouse have the option to roll over the funds into their own IRA, allowing them to defer distributions until they reach the required minimum distribution (RMD) age. At that point, they must take distributions on an annual basis which are calculated based on their life expectancy. Non-spouse beneficiaries, such as children or other individuals, who receive an IRA can also “roll over” inherited IRA assets into an inherited IRA for their own benefit. However, with certain exceptions for disabled beneficiaries and minors, these recipients must distribute out all the IRA funds to themselves (and pay the associated income tax) within ten years.

IRA Transfer

Similar to that during the account holder’s lifetime, IRAs can be transferred to a different IRA custodian, i.e. from financial institution to another, without tax consequences. This is important because it allows beneficiaries to maintain the tax-deferred status of the inherited IRA and continue to grow the assets over time. But why would you need to do such a thing after the death of the account holder? If the trust is named as the beneficiary of an IRA, some institutions will refuse to roll over an IRA into separate inherited IRAs for the trust beneficiaries, as the Trustmaker intended, despite “see-through” or “look-through” language in the trust directing that the oldest trust beneficiary’s life expectancy be used to qualify the trust for such treatment. These institutions will instead insist that the trust is a non-designated beneficiary, and must withdraw all IRA funds (and pay the associated income taxes) within five years or as a lump sum. This would unnecessarily compress the income tax window, resulting in higher taxes paid at a faster rate. In such a case, the Trustee of the Trust can elect to complete a custodian-to-custodian transfer, essentially “moving” the IRA to a friendlier institution that will comply with the trust directions, and get the inherited IRAs to the beneficiaries under the 10-year rule.

IRA Cash-Out (Distribution)

Although it is not used as often, perhaps obviously, for tax reasons, when an IRA account holder dies, beneficiaries have the option to “cash out” the IRA. This means electing to receive the funds as a lump sum or through periodic distributions. However, taking a cash distribution from an inherited IRA can result in significant tax implications. Beneficiaries who choose to cash out an inherited IRA are generally subject to income taxes on the distribution. So why would beneficiaries choose this option? For one thing, they may not have a choice. If the beneficiary of an IRA is an estate, it is not a designated beneficiary, which can take the funds out over five years or as a lump sum. This can happen when beneficiary forms are not updated after someone passes away, leaving a deceased person listed as the sole beneficiary of a retirement account. Additionally, even if a beneficiary would qualify for the 10-year rule, the size of the IRA may not justify the headache of stretching it out. For example, if 5 children are designated as equal beneficiaries of a $50,000 IRA, the children may wish to simply cash out their shares and pay the required income taxes on their individual distributions of $10,000 at their own income tax rate, particularly if this will not change the income tax bracket that applies to them.

In sum, there are specific rules and considerations regarding taxation and distribution requirements for beneficiaries of IRAs. Beneficiaries should carefully evaluate their options and consult with their financial advisor and/or tax professional to make informed decisions based on their individual circumstances and goals.