Who Should Your IRA Go To If You Die?

For many people, tax-deferred retirement accounts, like 401(k)s and IRAs, are a large part of their net worth. If this is true of you, planning for distributions from these accounts after your death is a vital part of your estate planning.

IRA beneficiary

You may already have beneficiaries in mind. But the seemingly simple question of, “Who should be my beneficiary?” can become complicated because of the complex rules governing distributions from these accounts. Here, we’ll walk through your beneficiary options, so that you can decide which best suits your estate plan.

IRA Beneficiary Options

Generally, you have the following choices when designating a beneficiary: (1) spouse; (2) other individuals (children, grandchildren, siblings, etc.); (3) a trust; (4) one or more charities; and (5) your estate.

If you intend to make charitable donations upon your death, then designating one or more charities as the beneficiaries of your IRA (or of a portion of your IRA) is a great way to avoid taxes, thus giving the charity more money.

When most beneficiaries withdraw from an inherited IRA, the recipient must include the amount of the distribution in his or her income and pay income taxes on the amount. But if a charity is the recipient of an IRA distribution, it won’t have to pay taxes on the amount received since it’s a tax-exempt entity. Further, donating your IRA to charity will result in a charitable deduction for your estate. This can be a great benefit to your other beneficiaries if you have a taxable estate.

However, if you are not charitably inclined or want your IRA to be available to support your family, then you must decide whether to designate individuals (your spouse or children) or a trust as the beneficiary. We’ll talk in a moment about why it’s inappropriate to designate your estate as beneficiary, even though that’s a legal option. Of course, the proper beneficiary designation depends on your specific circumstances and should be coordinated with your overall estate planning.

Withdrawal Rules for Designated Beneficiaries

Often one of the major goals when dealing with an IRA is to allow your beneficiaries to defer paying income tax by postponing withdrawals from the account for as long as possible. Basically, you can allow the beneficiary to “stretch” the IRA funds over his or her life expectancy.

Doing this has two income tax advantages: (1) the longer the applicable distribution period, the smaller the amount that is subject to immediate taxation; and (2) funds not required to be distributed remain in the IRA and grow tax-deferred over the beneficiary’s life. So your beneficiary can not only pay less in taxes, but also, ultimately, withdraw more from the IRA.

As the account holder, you may withdraw money from your IRA when you reach age 59 ½ without incurring a penalty, but you’re required to begin taking distributions when you reach age 70 ½. If you begin to take distributions during your lifetime, the minimum amount that you must withdraw during the year (the required minimum distribution (RMD)), is calculated using your life expectancy. However, if you die before making any withdrawals from your IRA, the IRA’s balance will be distributed either within 5 years of your death (the “5-year rule”), or over the lifetime of your “Designated Beneficiary.”

The 5-Year Rule: Under this rule, the entire IRA account balance is distributed within 5 years of your death, regardless of who receives the distribution. This rule removes all possibility of extended tax deferral, which means distributions under this rule could be very costly. The recipient will immediately pay income taxes on any amount received from your IRA.

This rule usually applies when there is no “Designated Beneficiary.” It’s important to understand that the legal definition of a Designated Beneficiary is more than the person or entity that is named on a beneficiary designation form.

Under the tax rules, a Designated Beneficiary is an individual who is named as a beneficiary of an IRA. A beneficiary that is not an individual (for example, an estate, a trust, or a charity) is not considered a Designated Beneficiary, and the 5-year rule will apply.

Note that if any “non-individual” is named as one beneficiary, then the IRA will be treated as having no Designated Beneficiary, even if there are also individuals designated as beneficiaries. This is why it’s important to consider your options when designating multiple beneficiaries for your IRA. However, there is an exception to this rule for certain types of trusts, as discussed below.

Stretch Distributions: Making distributions to a Designated Beneficiary over his lifetime is often referred to as a “stretch distribution” because the beneficiary is stretching the distributions over his or her own life expectancy. Stretch distributions allow the assets inside the IRA to continue to grow tax-deferred over the beneficiary’s lifetime. There are a few differences in the rules governing stretch distributions, depending on the identity of the Designated Beneficiary:

1. Surviving Spouse – If your surviving spouse is the sole Designated Beneficiary of the IRA, then it can be distributed over the surviving spouse’s life expectancy. Alternatively, your spouse may elect to roll over the plan assets into a new or existing IRA of his or her own. A rollover will allow your spouse to treat the IRA as his or her own, meaning withdrawals can be deferred until your spouse turns 70 ½, your spouse’s own life expectancy determines payouts and RMCs, and your spouse can name new Designated Beneficiaries.

2. Individual Other than Surviving Spouse – If the Designated Beneficiary is an individual other than your surviving spouse, the IRA can be distributed using the beneficiary’s remaining life expectancy. The difference here is that the other individual will not have the option of rolling the IRA funds over into a new account.

3. Multiple Designated Beneficiaries – If your IRA has multiple Designated Beneficiaries, it will be distributed using the life expectancy of the oldest Designated Beneficiary. However, if the IRA is divided into “separate accounts” with different beneficiaries for each separate account, then the distribution rules will apply separately to each separate account. In other words, the RMD will be calculated based on the life expectancy of the oldest beneficiary of each separate account.

This sounds complicated, but creating separate accounts can be good for your beneficiaries because this strategy can help minimize taxes and maximize the deferral of inherited IRAs. For example, if you designate your son, age 50, and your grandson, age 20, as the beneficiaries of your IRA, then each could use his own life expectancy if separate accounts are established. For your grandson, this means potentially stretching out his distributions for 63 years (the grandson’s life expectancy), instead of taking the distributions over your son’s life expectancy of only 34 years.

Using a Trust as a Beneficiary

A trust cannot be a Designated Beneficiary, even if named as a beneficiary, because it is not a person. However, if a trust that is named as a beneficiary meets the following requirements, it’s considered a “see-through” trust, and the beneficiaries of the trust (not the trust itself) are treated as having been designated as beneficiaries:

  1. Trust is valid under state law;
  2. Trust is irrevocable or becomes irrevocable at your death;
  3. Trust beneficiaries are identifiable from the trust instrument;
  4. Certain documentation (e.g., trust instrument or list of all beneficiaries) is provided to the IRA custodian by October 31 of the year following your death; and,
  5. All of the trust beneficiaries are individuals whose ages can be identified.

There are two types of see-through trusts: conduit trusts and accumulation trusts. A conduit trust requires that when the RMD is paid to the trust, the trustee must immediately pay the RMD to the income beneficiary of the trust. Thus, the RMD flows through the trust to the current income beneficiary (usually, your spouse or children).

The income beneficiary is treated as the sole beneficiary of the trust for purposes of determining the Designated Beneficiary, and his or her life expectancy is used when calculating the distribution period.

An accumulation trust allows the trustee to decide whether to accumulate the RMD in the trust when it is received or to pay part or all of it out to the income beneficiary. The drawback of an accumulation trust is that all trust beneficiaries are considered when determining the Designated Beneficiary.

Most trusts have a current beneficiary (e.g., your spouse), remainder beneficiaries who will receive distributions when the current beneficiary dies (e.g., your children), and “contingent” beneficiaries who would receive distributions if all current and remainder beneficiaries die (i.e., beneficiaries who would inherit if you, your spouse, and all of your descendants die in a plane crash). With an accumulation trust, the remainder and contingent beneficiaries are taken into account in determining the Designated Beneficiaries.

If you have named a charity as the “default taker,” then you have a “non-individual” beneficiary preventing stretch distributions. Even if you have named your “heirs” as default takers, a relative older than your spouse (your parents, for example) may be taken into account when determining the Designated Beneficiaries, and the RMD would be based on that older relative’s life expectancy, shortening the distribution period.

Drafting a trust that will be designated as a beneficiary of your IRA requires care to ensure that it reflects your wishes yet qualifies as a see-through trust. A conduit trust is the simplest option because the RMD will be distributed over the income beneficiary’s life expectancy.

However, one reason for creating a trust is to protect assets for beneficiaries who have financial or substance abuse problems. Structuring a trust as a conduit trust would defeat the purpose of allowing the trustee to accumulate assets in the trust and make distributions only when appropriate. Under these circumstances, an accumulation trust would likely work best, but take care to ensure that remainder and contingent beneficiaries do not disqualify the trust as a see-through trust.

Clearly, setting up a trust can be extremely complex, so it’s best to have a financial and legal advisor during this process. Before you speak with your advisor, consider who you want your trust to benefit, and how you want it to benefit that person or those people. Then, talk over your options carefully, and make the choice that best fits your situation.

Rules of Thumb for Designating Beneficiaries

As you can see, there’s no one size fits all answer for the question of who to designate as your IRA beneficiary. However, there are several rules of thumb:

1. Never, ever name your estate as the beneficiary of your IRA or other retirement plans. If your estate is the beneficiary, then the 5-year rule will apply and all income tax deferral is lost.

2. Be sure to designate a beneficiary. If your IRA does not have a beneficiary, then it will be distributed to your estate using the 5-year rule. If you have multiple accounts, be sure each has a designated beneficiary.

3. Designating individuals as beneficiaries is the simplest option because your spouse can take advantage of the spousal roller or separate shares can be created if multiple beneficiaries are named. This option often is used when the persons designated as beneficiaries are responsible adults.

4. Many of my clients create revocable trusts as part of their estate plan. If that is the case, I often recommend that the spouse be designated as the primary beneficiary, and the revocable trust be designated as the contingent beneficiary. That way, the spouse can take advantage of the spousal rollover and defer taking distributions until he or she turns 70 ½.

If the spouse predeceases, then the RMD would be paid to the trust, and, depending on whether the trust is a conduit trust or accumulation trust, the RMD would either flow through to the children as the beneficiaries or be accumulated and distributed at the trustee’s discretion. If you designate your revocable trust as the primary or contingent beneficiary of your IRA, be sure to work with your estate planning attorney to determine whether a conduit or accumulation trust better fits your goals.

5. Finally, be sure your beneficiary designations are coordinated with your estate planning documents. If you name your parents as beneficiaries, and then get married and make your spouse the primary beneficiary of your will or revocable trust but never change your IRA beneficiaries, upon your death, your parents will receive the IRA (which may be one of your largest assets). (Note that the rules may differ for 401(k), accounts where your spouse generally is the beneficiary unless he or she signs a waiver.)

Clearly, designating your IRA beneficiary is one of the more complex aspects of planning for your own death, which can be an uncomfortable process to begin with. Start by examining your goals, whether that’s allowing your spouse to continue in his or her current lifestyle should you pass away or putting your teenaged children through college should the worst occur. Then, you can work through your options to decide which of these IRA beneficiary designations will work best for you and your heirs.


Topics: financial planning

One Response to “Who Should Your IRA Go To If You Die?”

  1. A Buccie

    I really appreciate your article. Twenty five+ years ago, I named my parents as the main beneficiaries of my IRA accounts and have never changed this. I did this because I wanted my parents to have some sort of “future” income if something unexpected happened to me. Due to hard circumstances in their lives, they did not save for retirement as well as I have been able too. If I suddenly died, my thinking was that I would not be there to assist them in their retirement if they needed assistance. However, now, my parents are now 25+ years older (now over 80 years old) and by reading your article, I see that based upon their life expectancies, they would have to take very large distributions of my IRAs almost immediately and be burdened with real tax questions if I continue to have them as my IRA beneficiaries. I need to rethink this and take them off as beneficiaries of my IRA accounts and come up with a better way to have monies from my estate available to them should they need assistance.

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