Estate Planning : Naming The Right IRA Beneficiaries

The IRS turned IRA  planning upside down with new regulations in January 2001 and again in 2002. The new Estate Planning rules might change whom you name as IRA beneficiaries in your estate planning.

Much IRA estate planning used to involve minimizing required distributions by navigating the complicated tax rules. Now, we can plan differently. You can name the beneficiary that makes the most non-tax sense. You also have the flexibility to name additional beneficiaries and contingent beneficiaries so that your survivors can make the final choice. Most importantly, you don’t have to guess the order in which people will die to get the best results.

We discussed in detail how both sets of regulations affect required distributions. They also affect your choice of beneficiary for estate planning. Here are the steps you should consider when naming beneficiaries to maximize the many benefits of these regulations.

• Talk to your beneficiaries. IRA sponsors report a curious phenomenon. Original IRA owners often do a lot of work to determine the right beneficiaries and distribution method for their IRAs. They arrange for the tax deferral of their IRAs to last as long as possible. Yet, a significant number of beneficiaries want to liquidate the IRAs right away and take the maximum after-tax cash they can.You can name who is eligible to receive your IRA. You also can set things up so that the IRA can last as long as possible. You cannot keep the new owners from liquidating the IRA when they want, unless you name a trust as the beneficiary.Determine the goals of your beneficiaries. Find out if they plan to spend the after-tax cash or let the IRA compound tax deferred for some future use, such as their own retirement. If they plan to spend it, and you don’t want them to, consider naming a trust as the beneficiary. If you don’t care what they do with the IRA, at least you won’t waste a lot of time planning for a deferral that isn’t wanted.
• Take care of your spouse first. This should take priority over tax benefits and providing for succeeding generations. If there are not sufficient assets outside the IRA to maintain your spouse’s standard of living, your spouse should be primary beneficiary of the IRA. Other objects of your affection can be contingent beneficiaries who will take over after your spouse passes on.You do need to decide what will happen to the account after your spouse’s demise. One option is to name the spouse as beneficiary. That allows him or her to roll over the inherited IRA into a new IRA. This provides a great deal of flexibility, allowing the establishment of new beneficiaries and a new distribution schedule.Leaving the IRA outright to your spouse, however, means you do not control who eventually gets the account. You take the risk that a second spouse, children of a second marriage, other relatives, or a charity could become beneficiaries instead of your intended contingent beneficiaries. If that scenario concerns you, consider naming a trust as beneficiary or splitting the IRA into multiple IRAs. We’ll discuss both options.
• Consider splitting an IRA into multiple IRAs. The latest IRS regulations allow your estate or the beneficiaries who inherit an IRA to do a split. That permits each beneficiary his or her own distribution schedule. You might want to do the split now for several reasons.Splitting an IRA now allows you to name a separate beneficiary or group of beneficiaries for each IRA. You know which investments will go to each beneficiary. You are assured that the preferred beneficiary will get the account as long as he or she survives you. This approach also avoids conflicts between your beneficiaries and arguments over what to do when multiple beneficiaries inherit an IRA.The split also lets you name different contingent or subsequent beneficiaries for each account. That might give you more control over who gets any remaining money after the first beneficiary passes on.Splitting an IRA also can reduce estate taxes. When your spouse inherits the IRA, the marital deduction ensures no estate taxes are due, but the IRA uses none of your lifetime estate and gift tax credit. Only your spouse’s lifetime credit shelters the remainder of the IRA at his or her passing. If you don’t have other assets that can use up the estate and gift tax credit, consider splitting an IRA and having your children or grandchildren inherit enough to use up at least a portion of your lifetime credit.You might want to name a trust for the benefit of your children or grandchildren as the beneficiary, especially if they are underage. The trust will ensure the IRA is distributed the way you want. 
• Name a trust as beneficiary. A trust, as I’ve mentioned, can ensure that an IRA supports your spouse and eventually goes to your chosen heirs, not to the new family of your surviving spouse. A trust also is a good way to leave the IRA to children or grandchildren who are not prepared to manage the account. Further, the trust can ensure that the wealth is distributed for the purposes you prefer, not the spending preferences of the beneficiaries. A trust as IRA beneficiary is almost essential if you want to pass the IRA assets directly to young grandchildren.A trust is a valid IRA beneficiary if some conditions are met. The trust must be valid under state law or would be valid except that it doesn’t yet own any property. The trust also must be irrevocable or will become irrevocable upon your death. That means you cannot get back the property in the trust or change its terms. You can, however, change the IRA beneficiary (or have your estate change the beneficiary) before your demise, shifting away from the trust. The beneficiaries of the trust must be clearly identifiable from the trust agreement. Finally, proper documentation as defined in the regulations must be provided to the IRA custodian no later then Dec. 31 of the year after your death.When these requirements are met, then the oldest beneficiary of the trust will be treated as the beneficiary of the IRA when computing the required distribution schedule.For this strategy to work, you first draft a trust agreement, naming the beneficiary, the trustee, and the terms under which distributions are to be made. Then name the trust as the beneficiary on the form filed with the IRA custodian. There are some tricks and traps. It is best to work with an estate planner who is familiar and has experience with ira trusts or Retirement Plan Trusts.Be sure not to name a revocable or living trust, such as those used to avoid probate, as beneficiary. Also, do not name a QTIP trust set up for your spouse as the beneficiary. Either action would increase taxes and require faster distributions than you would like. These are just a couple of the traps that make it wise to select an experienced estate planning professional to draft your IRA trust. 
• Make charitable gifts through an IRA. Few people realize an IRA is a better way to make charitable gifts than a will.An IRA is included in the taxable estate and is potentially subject to estate taxes. In addition, when the beneficiary takes distributions from the IRA, the distributions are taxed as ordinary income. The after-tax cash that flows to the beneficiary from an IRA could be a fairly low percentage of the beginning value. When someone inherits non-IRA assets, the receipt of those assets is tax free, and the tax basis usually is increased to current fair market value. The assets might have been subject to the estate tax, but they can be sold tax free.When a charity receives a distribution from an IRA, there are no income taxes because the charity is tax exempt. The charity gets the benefit of the entire distribution. The IRA is included in your estate. The estate, however, gets a charitable deduction for the portion of the IRA that goes to the charity. The charity is indifferent to whether it inherits IRA or non-IRA assets. The rest of your beneficiaries, however, probably are better off inheriting non-IRA assets and letting the charity benefit from the IRA.The latest IRS regulations make this strategy easier. You can name a charity and one or more individuals as co-beneficiaries of your IRA. If the charity’s share is distributed to the charity before required distributions must begin, then the required distribution schedule for the other beneficiaries can be computed as though the charity never were involved.The disadvantage of naming a charity as IRA beneficiary is that the amount the charity will receive will fluctuate with the investment performance. In addition, if the charity is co-beneficiary with one or more of your heirs you don’t know how much the heirs will receive. At one point it might seem reasonable to give a charity one third of your IRA and your children the rest. A few months later the IRA’s value might decline substantially, leaving your children less than expected. Or the IRA might increase substantially, giving the charity far more than you would like. One way around this disadvantage is to name the charity as a contingent beneficiary. This allows your executor and beneficiaries to work together to leave the charity a reasonable amount. 
• Name a lot of contingent beneficiaries. The IRS regulations give your estate planning and beneficiaries a great deal of flexibility in determining the final amounts received by different heirs. The Designated Beneficiary doesn’t have to be determined until Oct. 31 of the year after your passing. I explained last month and in prior visits how this provision and disclaimers by the initial beneficiaries can be used to improve your estate plan.The flexibility in the regulations, however, can be used only if you name enough contingent beneficiaries. The Designated Beneficiary eventually named for the IRA must be among the initial or contingent beneficiaries you named on the form filed with the IRA custodian.
• Roll over employer plans to an IRA. An employer who sponsors a 401(k) plan isn’t required to provide all the planning options available through an IRA. A 401(k) sponsor has to make distribution options last only for up to five years. For that reason you might want to roll over your 401(k) to an IRA now, unless the 401(k) offers some excellent features.
• Consider an estate planning strategy of emptying your IRA early. Normally you want to defer taxes for as long as possible. Since an IRA requires minimum distributions after age 70 1/2, however, you might want to empty the IRA early. That’s because once required distributions begin, you might pay a lot of income taxes on forced distributions. The lifetime tax burden might be less if you begin distributions now and get the future gains and income out of your IRA.

The beneficiary designations on your IRA are among the most important decisions in your estate plan. Nothing in your will affects how the IRA is distributed. Carefully consider your beneficiary options. After making choices, add contingent beneficiaries so your estate administrator can have maximum flexibility. Finally, educate your heirs about your estate planning strategy and their options as discussed in last month’s visit.