IRA Beneficiary Designations, Not Always As Simple as One Might Think

IRA Beneficiary Designations, Not Always As Simple as One Might Think

It seems pretty simple to decide who you want to receive the gift of your IRA when you are no longer here.  If you are married, it is usually your spouse, sometimes your children, grandchildren, or maybe a charity.  In a blended family it may be your spouse as primary and then your children as contingent beneficiaries.  The advantage of the IRA beneficiary designation is that the account value passes to the beneficiary, bypassing your will and/or probate.  It seems pretty simple, but when you dive into deeper questions, the answers can become much more complex.  The subject of IRA beneficiary designations is very detailed.  One significant thing to note is that Arizona may protect inherited IRA’s from creditors (U.S. Supreme Court, Clark v. Rameker).

There are basically five options for naming beneficiaries:  1) Spouse, 2) Children, grandchildren or others, 3) Trusts, 4) Charity, 5) a combination of some or all of the above.

When do you leave to a spouse first?  When do you not?  If you predecease your spouse, leaving your IRA to them ensures that money will be available for them and the spousal rollover option can provide many more years of tax-deferred growth.  If your spouse is much younger, they can use a different life expectancy chart making Required Minimum Distributions even less.  Required Minimum Distributions (RMD) must be taken when the surviving spouse reaches the Required Beginning Date (RBD) of 70 ½ years of age.  The surviving spouse will name their own beneficiaries when the IRA is inherited which could potentially be problematic in a blended family.  In a blended family, there is nothing that disallows a surviving spouse from naming only their children as beneficiaries of the inherited IRA.  They are under no obligation to follow your wishes if you want your children to be beneficiaries of the inherited IRA.  Also, if your spouse is incapacitated, the court could take control of this money.  If your spouse needed public assistance (i.e., AHCCCS/Medicaid) the money would be considered part of their estate; possibly disallowing them from receiving state aid.

If the surviving spouse will have plenty of assets, you believe your spouse will die before you, or if you are not married, you could name your children, grandchildren or other individuals as beneficiary (ies).  Because, under the current law, the distributions can be paid over your beneficiary’s life expectancy after you die, the tax-deferred growth can continue.  The downside is anytime you name an individual as beneficiary, you lose control over how the IRA will be taken out.  The money could also be reachable by the beneficiary’s creditors, spouse and ex-spouse(s).  And there is a risk of court interference in the case of incapacity.  If any of this is a concern to you, consider using a trust to receive the IRA.

Naming a trust as a beneficiary will give you maximum control over your tax-deferred money after you die.  The distributions from the IRA will be paid into the trust that contains your written instructions stating who will receive the money and when.  For example, the trust could provide for your surviving spouse during their lifetime, and then the income could go to someone else.  The trust could provide periodic income to your children or grandchildren, keeping the remainder safe from irresponsible spending, spouses or creditors.  On the downside, when an IRA is transferred to a trust, many of the stretch payment provisions are lost.  A trust must use the life expectancy of the oldest beneficiary of the trust which would probably be the surviving spouse.  Also, many trusts pay income taxes at higher rates than most individuals.  This would only apply to money that stays in the trust.  This may not be a problem as the trustee of the trust has the authority to distribute the money to beneficiaries of the trust who will pay the income tax at their own tax rate.

If you are planning to leave an IRA to a charity after you die, a tax-deferred account can be an excellent one to use.  The charity will pay no income tax on the money and the account will not be included in your taxable estate when you die.  This reduces the amount your family may have to pay in estate taxes.

You don’t have to choose just one of these options.  You can divide a large IRA into several smaller ones and name a different beneficiary for each one.  If the money is still in your employer plan, it can be rolled into an IRA and then divide it (subject to IRS regulations).

If you name several beneficiaries equally for one IRA, the oldest one’s life expectancy will determine the payout after you die.  With an IRA for each beneficiary, each life expectancy will be used, providing the maximum stretch-out.

This is especially important if a beneficiary is a charity.  It has a life expectancy of zero, so the IRS would consider it the oldest beneficiary.  Depending on when you die, this could cause the IRA to be paid out in just five years.

If you divide your IRA now, you will need to calculate a distribution for each one, but it can be worth the trouble.  Under a new rule, your IRA can be divided even after you die. Splitting a large IRA can also save estate taxes.

You can change your beneficiary at any time while you are living and the distributions after you die will be paid over that beneficiary’s life expectancy.  It is also very important to name both primary and contingent beneficiaries while you are living to allow greater flexibility and administration after your death.  For example, your spouse could disclaim some benefits so a grandchild could inherit.  Of course, no new beneficiaries can be named after you die unless the beneficiary of your IRA names new ones, so make sure you include all appropriate ones.

Even though the rules are now simpler, they are still loaded with tax traps and penalties.  Please be sure you get professional advice, especially if you have a sizeable amount in tax deferred plans.

Raskob Kambourian Financial Advisors is an independent, fee-only comprehensive financial advisory firm registered with the Securities and Exchange Commission.  We offer expertise, competitive pricing, and personalized financial services to meet your “Life Planning” needs.