The 99% Rule for Spousal Beneficiaries of Retirement Accounts
It sounds funny to say, but death is a part of life for all of us. It’s one of the few things that all of us have in common at some point, and it’s one of the few issues that must be addressed in every plan. While every situation is unique and we all have our own goals and objectives, the overwhelming majority of married couples with IRAs and other similar accounts, such as 401(k)s and 403(b)s, name their spouse as their primary beneficiary as part of their estate plans. As such, knowing the rules for when a spouse inherits an IRA is critical for just about every married couple.
Unfortunately, the rules are not simple, especially when compared to the rules for when a child or other non-spouse beneficiary inherits the same account. That’s because there are a slew of special rules that only apply when a spouse inherits an IRA, and those rules can greatly complicate matters.
Consider the real-life case of Charlotte Gee, a surviving spouse beneficiary who learned this rule the hard way. After inheriting more than $2.5 million dollars in IRA funds from her deceased husband, Gee, who was younger than 59 ½ at the time, followed some bad advice and executed a spousal rollover of the full amount. Shortly afterwards, she took a distribution of $977,888 from the IRA. Although Gee reported the amount as taxable income, she did not factor in any 10% penalty because she said she was a beneficiary. The IRS challenged her on this, and ultimately the issue went to tax court, where Gee’s argument was swiftly dismissed, leading to a penalty of nearly $100,000 on top of the tax bill she already owed! The Tax Court’s reasoning was both accurate and succinct:
“…once [Gee] chose to roll the funds over into her own IRA, she lost the ability to qualify for the exception from the 10-percent additional tax on early distributions. The funds became petitioner's own and were no longer from her deceased husband's IRA once petitioner rolled them over into her own IRA.”
Perhaps if Gee had been more knowledgeable about the special rules that apply to spouses, or had she worked with an advisor who understood “the 99% rule,” this never would have happened. The 99% rule can help bring some much-needed clarity to the spousal beneficiary rules, but to understand it, one must first understand the options a spousal beneficiary has at their disposal.
One option a spousal beneficiary can choose to utilize is to establish an inherited IRA, similar to the way a non-spouse beneficiary can. When doing so, a spouse must move money directly from the decedent’s IRA to an inherited IRA, and they must properly title the account. While the precise titling can vary slightly from custodian to custodian, the titling must include the name of the decedent, as well as indicate, somehow, that the account is an inherited or beneficiary IRA. For example, an acceptable titling might look like this:
John Doe (deceased xx/xx/xxxx) IRA FBO Sally Doe
When a spouse chooses to remain a beneficiary of an IRA, they are able to take penalty-free distributions from the account at any age and at any time. Thus, young spouses should pay particular attention to this option. In case you’re wondering what “young” is, the tax code, at least in this case, would define young as anyone under the age of 59 ½.
The second option for a spouse beneficiary, and one available only to a spouse beneficiary is to complete what is commonly referred to as a “spousal rollover.” In a spousal rollover, a surviving spouse takes a distribution from their deceased spouse’s IRA or a beneficiary IRA they inherited from the spouse and moves the funds, either directly, or indirectly within 60 days, to their own IRA. This is an irrevocable decision by a surviving spouse. Once the funds are deposited into their own IRA, they are treated as if they were always in the account. There is no way, at this point, for the surviving spouse to change their mind and be treated as a beneficiary.
A third option allows a spouse to treat a deceased spouse’s IRA as their own. This option, though, is seldom used in the real world and has the same tax consequences as a spouse completing a spousal rollover.
With multiple options to choose from, a commonly asked question is “Which option is best?” The answer, of course, differs depending upon the unique set of factors and circumstances surrounding the surviving spouse, but surprisingly, there is a general rule of thumb that 99% of the time will give you the right answer. Alright, so maybe it’s not exactly 99% of the time, but you get the point. It’s a pretty darn reliable strategy. Here’s the rule, in a nutshell:
The 99% Rule
If a surviving spouse beneficiary is under 59 ½ at the time they inherit an IRA from their deceased spouse, then the rule says that 99% of time the correct planning move is to establish an inherited IRA for the surviving spouse’s benefit. The funds should continue to be kept in an inherited IRA until the surviving spouse turns 59 ½. Once the surviving spouse turns 59 ½ — or if they are already over 59 ½ when they inherit — a spousal rollover can be executed.
So why is this strategy right more often than not? For the simple reason that there is almost never a downside to using it. It almost always allows a surviving spouse maximum flexibility without hindering them in any way. Some might dispute that notion and point to the fact that, by remaining a beneficiary of an inherited IRA, it would lead to the surviving spouse having to take required minimum distributions prematurely (before they turn 70 ½), but that logic would almost always be flawed.
Unlike other beneficiaries who must typically begin taking required minimum distributions from their inherited IRAs by December 31 of the year after the IRA owner dies, a surviving spouse generally does not have to start taking RMDs from an inherited IRA until their deceased spouse would have been 70 ½. Since most spouses are relatively close in age, it’s a rare scenario that would force a spouse to choose between maintaining a penalty-free inherited IRA and moving the inherited IRA funds to their own IRA to avoid RMDs.
Example: Jack is married to Jill and has named her as the sole beneficiary of his IRA. Jack is 55, and Jill is 50. Unfortunately, Jack dies unexpectedly. In this scenario, Jill should, without hesitation, follow the 99% rule and establish an inherited IRA, remaining a beneficiary until she reaches 59 ½. This is the only approach that makes sense here.
Consider that, as a beneficiary, should Jill need to access her inherited IRA funds for any reason, she would be able to do so without incurring the 10% penalty. Furthermore, since Jack and Jill are relatively close in age, there will never be a time when Jill would be forced to take RMDs from the inherited account. When she initially inherits the account, at 50, Jack was just 55, much younger than the key age 70 ½ that would require Jill to take RMDs from her inherited IRA. Similarly, when Jill turns 59 ½, Jack would still only be 64 ½, had he lived. Thus, no RMDs would be required at that time either. In fact, by the time Jack would have been 70 ½, triggering RMDs for the inherited IRA, Jill would already be 65 ½. By that point, following the 99% rule, she should have already made a spousal rollover of the inherited funds into her own IRA (at age 59 ½). Following that spousal rollover, as noted earlier, the funds would be treated as if they were always in Jill’s IRA, allowing Jill to continue to delay RMDs until she turns 70 ½.
Similarly, some might point out that if a surviving spouse dies with an inherited IRA, the beneficiaries will be stuck using the surviving spouse’s life expectancy and will be unable to stretch distributions over their own lives. While this is possible, thanks to another special rule for spousal beneficiaries, it is once again unlikely. That’s because as long as the surviving spouse dies prior to when the deceased spouse would have been 70 ½ (the same age as when RMDs would need to begin), the surviving spouse’s beneficiaries can still use their own life expectancy.
Let’s bring back our friends Jack and Jill. Recall that Jack died at 55 and Jill, who was 50 at the time, followed the 99% rule and established an inherited IRA. Now imagine that Jill has named her children as the beneficiaries of her inherited IRA. Unfortunately, tragedy strikes again, and Jill dies only a few years later when she’s 53. If Jill were anyone other than a spousal beneficiary, her children would be stuck using her shorter life expectancy. As a spousal beneficiary, however, and because Jack would not yet have been 70 ½ (Jack would only have been 58), her children will be able to stretch distributions out over their own life expectancies.
Thus, as you can see, the two biggest downsides of inherited IRAs — RMDs and the loss of the stretch IRA for future generations — are often not an issue when a spouse inherits an IRA. That said, I call it the 99% rule and not the 100% rule because it’s not always the best option. So when does the 99% rule not work? In the rare, but certainly not unheard of circumstance, where the surviving spouse is significantly younger than the deceased spouse. It’s what I like to call The Modern Family Conundrum.
On the popular ABC sitcom Modern Family, Ed O’Neill (think Al Bundy from Married… with Children) is married to the vivacious Sofia Vergara. While they’re not married in real life, let’s imagine for a moment, that they are. O’Neill just turned 71 years old and is subject to required minimum distributions for any IRA accounts he owns, while Vergara is just 44. If O’Neill were to pass away and leave Vergara his IRA, she’d have a choice to make.
She could either leave the account as an inherited IRA, which would:
1) Allow her to continue taking penalty-free distributions prior to 59 ½
2) Force her to begin taking required minimum distributions from the inherited IRA
3) Require her beneficiaries to continue distributions over her life expectancy, should she pass away while still remaining a beneficiary
…or she could execute a spousal rollover, which would:
1) Make future distributions prior to age 59 ½ subject to the 10% early distribution penalty unless another exception applied
2) Allow her to delay taking required minimum distributions until she reached 70 ½
3) Allow her beneficiaries to use their own life expectancies whenever she passes away
Now there’s a good chance that if Sofia Vergara were really put in this situation and forced to make a choice, she’d opt for the spousal rollover. I have a sneaky suspicion that she wouldn’t have a need to dip into the inherited IRA anytime soon. She is, after all, the highest paid actress on TV for five years running now (according to Forbes). You, however, may not be in the same boat.
There are other times when it pays to buck the 99% rule as well. For instance, when a much older spouse –already past 59 ½ - inherits an IRA from a much younger spouse, it still pays to remain a beneficiary.
There’s a lot of technical information in the tax code that frankly, is not all that applicable to the majority of people out there. The special IRA spouse beneficiary rules, however, do not fall into that category. If you’re married there’s a good chance that your spouse is your primary beneficiary, in which case these rules should be important to you! So get comfortable with the 99% rule, but be sure you can identify the rare exceptions when it doesn’t apply.