Designating a Beneficiary of your IRA
The IRS does not allow you to keep retirement funds in a tax-deferred retirement account forever. When you reach 70½ years of age, you must start taking required minimum distributions (“RMD”) from your individual retirement account or qualified plan. The RMD is the minimum amount you must withdraw from your retirement account each year. You can always take more than the RMD. However, the consequence for failing to take the RMD is a 50% excise tax on the amount not distributed.
If you do not withdraw all of your retirement funds before you pass away, designating the right beneficiary of your retirement account will enable your heirs to continue the income tax deferral. An individual (such as your spouse, children, or grandchildren) or an entity (such as your estate, charity, or trust) may be designated as the beneficiary although the rules set forth under the Internal Revenue Code differ depending on the beneficiary designation.
If you are married and designate your spouse as the sole beneficiary of your retirement account, your spouse has several options with regard to the distribution of the account after your death. Your spouse can assume ownership of your retirement account by rolling it into his or her own account. This allows your spouse to delay the RMD until he or she turns 70½ years as well as make additional contributions and designate his or her own beneficiaries.
Absent a rollover, your spouse can treat your retirement account as an inherited IRA. If, at the time of your passing, you already started taking the RMD, your spouse has the option of basing the RMD on his or her own current age or on your age at the time of your death. On the other hand, if you were not required to take the RMD at the time of your passing, your spouse must withdraw all of your funds within 5 years of your death or may wait to take the RMD until you would have been required to at 70½ years of age.
If you designate your children, grandchildren or other individuals as beneficiaries of your retirement account, their options depend on whether you were required to take RMD during your lifetime. If, at the time of your passing, you already started taking RMD, your beneficiary will take distributions based on the younger of the beneficiary’s age or your age at the time of your death. However, if, at the time of your passing, you were not required to take RMD, your beneficiary may take a lump sum distribution of the funds in your account within 5 years of your death or take distributions based on his or her own age. By stretching out the distributions over the beneficiary’s life expectancy, your retirement funds (except for RMD) will stay in an inherited IRA account continuing to grow tax-deferred resulting in a substantial growth over the lifetime of the beneficiary.*
You can name an entity (such as your estate, charity, or trust) as the beneficiary of your retirement account; however, because an entity is not a person, in most cases, it will not be considered a “designated beneficiary,” and therefore, postdeath income tax deferral will be limited or unavailable. If an entity is named as your beneficiary, and at the time of your passing, you already started taking the RMD, your retirement funds must be distributed to the entity over your remaining life expectancy. However, if an entity is named as your beneficiary, and at the time of your passing, you were not required to take RMD, your retirement account must be distributed to the entity within 5 years of your death.
If you name an estate as your beneficiary, your retirement funds will be subject to probate and your heirs will not have the distribution options that would have otherwise been available to them if they were designated as individual beneficiaries.
If you name a charity as your beneficiary, and your estate is subject to federal estate tax, you will receive a charitable estate tax deduction. Plus, there will be no income tax liability associated with your account once in the hands of the charity.
If you name a correctly structured trust as your beneficiary, you maintain maximum control over the management and distribution of your retirement account. If the trust meets certain IRS requirements, it will qualify as a see-through trust and the oldest beneficiary of the trust will be treated as the designated beneficiary and the RMD will be paid to the trust over his or her life expectancy. Your remaining funds will stay in the account continuing to grow income tax-deferred as if you named the trust beneficiary directly as an individual beneficiary.
You can designate both an individual and an entity. If an entity is named as a beneficiary of only a share of your retirement funds with an individual beneficiary receiving your remaining funds, the individual beneficiary may be treated as a designated beneficiary if, within a year of your passing, the entity takes a lump sum distribution of its share, or if your funds are divided into separate accounts for each beneficiary.
You can designate several beneficiaries of your account; however, the distributions will be based on the life expectancy of the oldest beneficiary. In the alternative, you can split your account into separate shares and name a different beneficiary for each share. This would allow the life expectancy of each beneficiary to determine distributions for his or her respective share.
*A proposed law may eliminate the ability of a non-spouse individual beneficiary to stretch an inherited IRA, which may have a drastic impact on such beneficiary’s financial security. Stay tuned for any legal changes to this valuable estate-planning tool.