The most frequent, most expensive mistakes with IRAs occur when it’s time to pass the IRAs to the beneficiaries. Sometimes the fault is with the original owner. Sometimes the fault is with the beneficiaries.
In either case, the mistakes cause the tax-deferred compounding of the IRA to be lost. Income taxes are paid earlier than they needed to be, and beneficiaries have less after-tax wealth than they could have. Most owners of large IRAs say they don’t plan to use all of the IRAs during their lifetimes. They’re saving as much of the balances as possible for the next generation to inherit. They also hope the beneficiaries will keep the bulk of the assets in the IRA for years, or even decades, so the tax-deferred compounding can continue working.
Yet, mistakes made when trying to navigate the tax law cause the IRA to be taxed earlier than hoped. A new obstacle to extending the life of your IRA is a law making its way through Congress. See the next article in this issue for details about that. Here’s a checklist that every IRA owner and beneficiary should review to make an IRA last as long as possible under current law.
The beneficiary form is the first key to maximizing the after-tax wealth of an Inherited IRA. To maximize the tax deferral of an IRA for your heirs, you need to name one or more individuals, and only individuals, as beneficiaries on a valid beneficiary form.
The only exception is a qualified trust as beneficiary, but it must be a trust with the right terms. If you don’t name a beneficiary of your IRA, your estate will be considered the beneficiary. Under IRS regulations, when an estate is the beneficiary, the entire IRA must be distributed and taxed quickly, usually within five years.
The same rule applies when the wrong kind of trust is named beneficiary or when you name any beneficiary other than an individual. Your beneficiary designations should be reviewed any time there is a major life event in your family, such as a birth, adoption, marriage, divorce, death, or someone coming of age.
It’s a good idea to take a look at the designations every few years, even if there hasn’t been a major life event, in case you changed your mind. Most estate planners recommend that you also name contingent beneficiaries and that they all be individuals. If your primary beneficiaries predecease you, choose to disclaim the inheritance, or for some other reason aren’t able to inherit the IRA, you want other individuals to be able to do so. Otherwise, your estate becomes the beneficiary and the IRA must be distributed within five years.
Another good idea is to name a charity as a final contingent beneficiary to ensure the estate never is beneficiary. There are good reasons to name a trust as an IRA beneficiary. The main reason is the intended beneficiaries are minors or it is feared they wouldn’t be responsible with the money. So, a trust is created to ensure the beneficiaries are provided for but aren’t able to waste the money. The trust is the IRA beneficiary, and the individuals are beneficiaries of the trust. But a trust must have specific terms when it is the IRA beneficiary.
Otherwise, the IRA must be distributed within five years. We discussed the trust rules in detail in our May 2017 issue.
Another key point is the IRA designation form must name the trust as the beneficiary. Many people have the trust drafted and then forget to name the trust on the beneficiary designation form. In addition to naming proper beneficiaries, the IRA owner needs to keep a current copy of the beneficiary designation form for each IRA. Be sure your executor and other key people know how to find the forms. If people can’t locate the forms, there might be legal and other fees incurred to determine who has the right to the IRA. Of course, there also could be higher taxes.
You shouldn’t rely on the IRA custodian to have the most current beneficiary designation form. Errors can be made, especially when there are mergers, changes of ownership or moves to new locations. You need to keep a copy of the latest form; be sure it is dated and write “superseded” or something similar on old forms.
Once the IRA owner has the beneficiary designation forms squared away, the beneficiaries need to know the actions they need to take and the mistakes to avoid. You should talk with your beneficiaries about your intentions and theirs for the IRA. IRA custodians report that a high percentage of beneficiaries fully distribute inherited IRAs within a few years. They don’t try to have stretch IRAs that take advantage of tax-deferred compounding for years.
What’s not known is if this is deliberate or if it’s done because they don’t know all the options they have and the value of the tax-deferred compounding. When your goal is to have the IRA provide for your beneficiaries over the years, tell them that and let them know the steps they need to take. The first step for a beneficiary is to be sure the IRA is properly retitled.
Many beneficiaries mistakenly contact the IRA custodian and say they want the IRA shifted into their names or rolled over to their existing IRAs. Either move makes the full IRA balance immediately taxable. Instead, the account needs to be retitled as an inherited IRA. The new title of the IRA should contain the name of the original owner, that he or she is deceased, and that the IRA is being held “for the benefit of” or “FBO” the beneficiary.
Each IRA custodian has a variation of the wording. The beneficiaries also should double check and be sure only individuals are potential beneficiaries. If any non-individuals are beneficiaries, they can be removed by having their shares fully distributed to them or by splitting the IRA into separate IRAs for each beneficiary. Finally, the beneficiaries must begin RMDs by Dec. 31 of the year following the owner’s death.
When the first RMD is missed, the beneficiaries still might be able to remedy the situation. They can distribute the RMDs that should have been taken and pay the penalties for not taking them on time. (Or they can apply for a waiver of the penalty. See our April 2019 issue for details.) Then, they can take the rest of the RMDs on schedule. Beneficiaries always can take more than the RMD. But they have to take at least the RMD each year if they want the option of maximizing the IRA’s tax deferral.