IRA Beneficiary DiscussionSubmitted by MD Wendell Wealth Partner on March 31st, 2014
By Mark Wendell
Everyone should take time to go through a periodic estate plan review with a qualified professional financial advisor. This process may be simple or very complex, depending upon the nature and size of an estate. Many potentially perilous tax and/or penalty situations for the inheritor of Individual Retirement Account (IRA) assets can result from a lack of vigilance either when the IRA owner sets up the account or in the way the beneficiary accepts the assets.
If the owner of an IRA dies before complete distribution of assets, regardless of the specifications of a will or a trust, it’s important that the IRA’s designated beneficiaries 1) be clearly named and 2) be permissible under IRS rules for tax deferral purposes. Naming beneficiaries requires a clear understanding of those rules and also the distribution implications beneficiaries will have to consider following an IRA owner’s death, if it’s important to the recipient to maintain the assets’ tax-deferred status. If the process adheres to the IRS’s strict requirements, funds inherited from an IRA can be received by beneficiaries and not be subject to income taxation until distributed later.
After reaching age 70½, a Traditional IRA owner is generally required by federal tax law to withdraw a minimum amount from retirement savings plans each year — Required Minimum Distributions (RMDs). Depending on whether the IRA owner dies before or after this age, differing IRS rules apply that define how the beneficiary must withdraw RMD funds on an Inherited IRA. Beneficiaries are permitted to withdraw more than the required RMDs on an accelerated schedule if they wish to do so.
Listed below are basic guidelines about complex IRS rules covering inherited Traditional IRAs (inherited Roth IRA rules are very similar, but not covered here). However, a qualified professional must be consulted to be assured that details of a specific situation are considered.
- In the event a spouse is named as the beneficiary, the IRA may either be rolled into a personal Traditional IRA or the IRA of the deceased may be continued as the beneficiary’s Inherited IRA. If the choice is an Inherited IRA, there is not a 10% penalty for distributions regardless of the recipient’s age, unlike funds withdrawn from a personal Traditional IRA where a penalty would apply if payout is made to someone younger than 59½. RMDs for an Inherited IRA would be calculated based upon whether the original owner had attained the Required Beginning Date (RBD) — April 1 in the year after that in which the IRA owner turned 70½. If death occurred younger than 70½, RMD’s are not required by the surviving spouse until the deceased would have achieved the RBD. The RMDs would be based upon the surviving spouse’s life expectancy. Inherited IRAs cannot be rolled into a Roth IRA, nor can the RMD be rolled into a personal IRA. RMD’s are also required with Inherited Roth IRAs, and only earnings are taxable upon withdrawal if the “5-year rule” of the original owner is not satisfied (the Roth IRA must have been in existence for 5 years to avoid earnings, not principal, taxation).
- In the event no beneficiary is named, the ultimate recipient of the IRA will have a shorter time period of five years to withdraw the IRA funds than if one had been named, if the RBD had not yet occurred by the deceased. However, if the RBD was achieved by the deceased, then the maximum tax deferral available will be the remaining life expectancy of the deceased IRA owner.
- In the event a non-spouse person is named as beneficiary, then the RMD is calculated on the life expectancy of the beneficiary, regardless of whether the original IRA owner had or had not achieved the RBD prior to death. Distribution is permissible over a five-year period without penalty. The deceased owner’s IRA cannot be rolled over into a beneficiary’s IRA. If the original non-spouse beneficiary dies prior to the assets being fully distributed, the new beneficiary is known as a successor beneficiary, and is subject to the same rules, except that distributions must continue on the original beneficiary’s RMD schedule to maintain the tax deferral status.
- In the event the decedent’s estate is named as the beneficiary, the IRA may be subject to the decedent’s creditors’ claims. Distributions to heirs of an estate are dictated by state law, which could result in distribution to unintended IRA beneficiaries. Funds distributed directly to an estate account may subject the entire account to immediate taxation.
- In the event no contingent beneficiary is named or the named beneficiary has predeceased the IRA owner, then the IRA will be deemed to have no designated beneficiary. If this situation occurs, the wording of the IRA agreement specific to the IRA’s managing financial institution may determine the recipient.
- In the event an unintended beneficiary is named as a result of neglect in updating the appropriate documents, the IRA funds may go to that person. This can occur as a result of out-of-date pre-nuptial or post-nuptial agreements, changed family status or circumstances, or by overlooking needed changes to IRA accounts after updates to other estate-planning documents were done. A common example is when ex-spouses have been left as named beneficiaries in IRA documents that have not been kept up-to-date.
- In the event a named beneficiary is not a legal entity for beneficiary purposes, the entire tax status of the IRA account may be in jeopardy. This can occur, for example, if the spouse’s IRA account, rather than the named spouse, is specified as the beneficiary or when a pet has been named the IRA beneficiary, since neither a financial arrangement nor a cat or dog is legally considered a person. This might cause the entire IRA to become, by default, part of the IRA owner’s estate, with disastrous tax implications, unless a contingent beneficiary has also been designated.
- In the event a trust is named beneficiary: 1) it must be valid under state law, 2) it must become irrevocable upon the IRA owner’s death, 3) a list of its beneficiaries must be identifiable, and 4) the trust document must be provided to the trustee or custodian by October 31 in the year following the IRA owner’s death. If the trust is properly drafted and these four rules are followed, it is deemed a qualified trust for beneficiary RMD purposes. However, the rules for distribution are rather complicated and require professional advice to avoid potential tax issues. Naming a trust as a beneficiary may provide some long-term control over the disposition of the assets, for example for the benefit of a child or to provide for an ex-spouse and family, if the trust is carefully designed to account for IRA beneficiary intentions. Trusts are complex instruments and great care must be taken, when designating them as beneficiaries, to avoid unintended consequences.
IRA owners can avoid time-consuming complications or unintended consequences by having qualified professionals conduct periodic reviews of all documents related to designating beneficiaries to ensure their legality, accuracy and consistency with desired estate-planning goals.