The Ghost-Life Rule and Other Beneficiary Hauntings

Most people are not familiar with the ghost-life rule, but it can spook beneficiaries with a potentially large tax bill. The rule is dependent on the IRA owner having reached their required beginning date (RBD) for taking required minimum distributions (RMDs)—currently April 1 following the year the owner attains age 73—on or before the date of their death and a nondesignated beneficiary (NDB) inheriting the IRA.

There is enough tax talk in that paragraph to give someone the heebie-jeebies, so let’s start with the three beneficiary designations for inherited IRAs.

• Eligible designated beneficiary (EDB): Five groups—surviving spouse, minor child of the deceased (up to age of majority), disabled individual, chronically ill individual and an individual no more than 10 years younger than the IRA owner—who can take lifetime distributions.
• Noneligible designated beneficiary (NEDB): Most adult children, grandchildren and other non-EDB individuals; must deplete IRA assets by the end of the 10th year after the IRA owner’s death.
• Nondesignated beneficiary (NDB): Includes estates, nonqualifying trusts and charities. They are subject to the ghost-life rule.

RMDs are required to be taken by all three types of designees if the IRA owner died on or after their RBD. Surviving spouses have the most flexibility, including the option to make the inherited IRA their own IRA.

Nondesignated beneficiaries differ from EDBs and NEDBs in an important way: They are entities, not people. This matters because they do not have a measurable life expectancy to use for calculating RMDs.

This is where the ghost-life rule comes into play. As I explained in a recent Retirement Investing weekly, RMDs for nondesignated beneficiaries are based on the deceased person’s remaining life expectancy. Specifically, nondesignated beneficiaries use the IRS single life expectancy factor of the deceased account owner in the year of death minus 1.0. Each following year, the factor decreases by 1.0 from the previous year’s factor until all assets are distributed.

Here’s an example. The deceased account owner’s single life expectancy factor is 8.1. The first RMD is calculated by dividing the previous year’s ending balance by 7.1 (8.1 – 1.0). For a $500,000 account, that’s an initial RMD of $70,423. The next year’s RMD calculation will use a factor of 6.1 (7.1 – 1.0), and so on.

The older the account owner is at death, the faster the full balance will need to be withdrawn. Depending on the size of the account, these withdrawals could push the heir into a higher income tax bracket or a higher Medicare premium based on the income-related monthly adjustment amount (IRMAA).

You can avoid having your heirs be subject to the ghost-life rule by listing them as beneficiaries on your accounts. If you intend to have a trust inherit your IRA instead, check with your estate attorney about the potential tax implications for the type of trust you will use.

The ghost-life rule never applies to Roth IRAs because the account owner is always considered to have died before their RBD. As such, inherited Roth IRAs are subject to the five- and 10-year withdrawal rules but not RMDs.

Other Beneficiary Hauntings

There are other ways that mistakes with your beneficiary designations can create an unnerving experience for your family and other heirs.

• Failing to Name Beneficiaries: If no beneficiaries are listed, the account will go to probate. This is costly and time-consuming, and it will make the account part of the public record.
• Not Updating Your Beneficiaries: Financial institutions and retirement plan administrators follow what is listed on the beneficiary forms. We’ve seen several court cases over the years where a family member didn’t inherit an account because the beneficiary information was not updated.
• Naming Your Estate as the Beneficiary for an IRA: This subjects your IRA to the ghost-life rule and the potential higher taxes that come with it.

You can avoid these mistakes by checking the beneficiary information on all your accounts, retirement plans, life insurance policies and other beneficiary-designated assets annually. Ensure the information is correct. As you do this, consider adding a contingency (secondary) beneficiary in case you outlive the primary beneficiary.

Following these guidelines will keep your heirs from being horrified by unexpected tax or estate planning issues.