Many people make serious mistakes when naming beneficiaries for IRAs and similar accounts. Talk to almost any financial planner or estate planner and you’ll hear wild stories. People often have no beneficiaries named. Or a divorced or deceased spouse is the primary beneficiary. Some of the mistakes are so bad they end up in court. (See our August 2011 visit, available in the IRA Watch section of the Archive on the members’ web site.)
Remember, your will doesn’t affect the distribution of IRAs, 401(k)s, annuities, and life insurance. That’s why you need to review your beneficiary designations every couple of years and when there’s been a change in your family.
Until 2002, income tax considerations were a major factor in beneficiary selection. Under the IRS rules in effect at the time, the choice of beneficiary greatly influenced the calculation of required minimum distributions for the owner. Now, the beneficiary choice doesn’t have much of an effect on your RMDs, so you don’t factor that into your decision.
Here’s a structure for considering who should be named the beneficiary.
? Talk to your beneficiaries. IRA sponsors report a curious phenomenon. IRA owners often do a lot of work to arrange their IRAs so the tax deferral lasts as long as possible. Yet, a significant number of beneficiaries liquidate the IRAs right away, pay the taxes, and spend the rest.
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. If they plan to spend it, and you don’t want them to, consider naming a trust as the beneficiary. If some heirs plan to spend and some don’t, consider naming the savers as IRA beneficiaries and leaving other assets to the spenders. That’s because inheritors of IRAs will pay income taxes when they take distributions. Inheritors of other assets can sell them free of income taxes and spend the full amount.
? 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.
Leaving the IRA outright to your spouse, however, means you do not control who eventually gets the account. You take the risk that a subsequent spouse or children of a subsequent 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 with your spouse as the primary trust beneficiary. Also consider splitting the IRA into multiple IRAs. We’ll discuss both options.
? Consider splitting an IRA into multiple IRAs. The estate or the beneficiaries who inherit an IRA can split it tax-free into separate IRAs for each beneficiary. That permits each beneficiary his or her own distribution schedule and investment strategy. Yet, you might want to do the split now for several reasons.
Splitting an IRA allows you to name a separate beneficiary or group of beneficiaries for each IRA. You know which investments will go to each beneficiary. 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.
? Name a trust as beneficiary. A trust 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, a trust ensures spending of the IRA is deferred until the beneficiaries reach a certain age or other conditions are met, instead of being spent quickly. A trust as IRA beneficiary is almost essential if you want to pass the IRA assets directly to young grandchildren.
You need a good estate planner to name a trust as a valid IRA beneficiary. When the trust doesn’t have the right terms, the beneficiaries must distribute the IRA quickly and pay income taxes. They lose the benefit of deferral. When the trust has the right terms, required distributions are made using the age of the oldest beneficiary of the trust.
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 regarding the terms of the trust. 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 for your spouse as the beneficiary. Either action would increase taxes by requiring faster distributions.
? Make charitable gifts through an IRA. Few people realize an IRA is a better way to make charitable gifts than using a will to give other assets in the estate.
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 is less than 100% of the beginning value. How much less depends on the estate tax rate and the beneficiary’s income tax rate. 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 is the IRA beneficiary, the IRA still is included in the estate. But the estate takes a charitable deduction for the portion of the IRA for which the charity is the beneficiary. When the charity receives a distribution from the IRA, there are no income taxes because the charity is tax exempt. The charity gets the benefit of the entire distribution. The charity is indifferent to whether it inherits IRA or non-IRA assets. When you’re going to give part of your estate to charity, the rest of your beneficiaries probably are better off inheriting non-IRA assets and letting the charity benefit from the IRA.
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 money than expected. Or the IRA might increase substantially, giving the charity far more than you would like.
? Name contingent beneficiaries. Your executor and heirs have some time to determine who ultimately receives the IRA. They can examine their cash needs and income tax situations and ultimately let the IRA be inherited by the heir who would receive the most after-tax benefit. For this to work, however, you have to name a number of contingent beneficiaries so all the beneficiaries can work together and with the executor for the best results. We discussed how this works in some detail in the November 1999 visit, which is available in the Estate Watch section of the Archive on the members’ web site.
? Consider emptying your IRA early. Normally you want to defer taxes for as long as possible. Since an IRA requires minimum distributions after age 70½, however, you might want to empty the IRA early. That’s because once RMDs 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. You can find detailed discussions of this in the IRA Watch section of the web site Archive and in my book The New Rules of Retirement.
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 executor can have maximum flexibility. Finally, educate your heirs about your plan.
RW April 2012.
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