You may enjoy watching the earnings within your IRA grow tax-deferred, but someone, some day, will pay the tax. When you die, this responsibility falls on your heirs. The IRS lets them stretch out their Required Minimum Distributions (RMD), which can help reduce the tax burden. However, if the beneficiary designations are not set up correctly, your loved ones could pay more taxes than necessary.
You can leave your IRA to your spouse, a non-spouse, a trust, a charity, or an estate. Each beneficiary has unique tax rules to follow when they receive the funds.
Spouses have the greatest flexibility
Spouses can roll the account into their IRA. If they are younger than the deceased, they can defer the income taxes longer since they will not have to take any RMD until they are 70½. If the funds are needed, they could take a lump sum distribution and face a bigger tax bill, but this expense would reduce their taxable estate.
Spouses under the age of 59½ may want to remain treated as a beneficiary. Then they could take out money without paying the 10% penalty assessed to account owners who are under 59½. Once they pass 59½, they could roll the IRA into their own and continue to withdraw money penalty-free.
Prior marriages can present a unique situation
Account owners with children from a prior marriage might name their current spouse as their IRA's primary beneficiary with their children as the contingent beneficiaries. The problem is that when they die, their spouse could roll the account into their own IRA and name new beneficiaries. The deceased's children might get nothing. A qualified terminable interest property (QTIP) trust could eliminate this dilemma.
A QTIP trust would provide for the surviving spouse while passing any remaining interest to the children after the spouse dies. There are some downsides, though. Surviving spouses cannot roll over the QTIP trust funds into their IRA. They'll thereby miss out on the ability to defer distributions until they reach 70½. Also, the children cannot use their life expectancies in figuring the annual RMD. Instead, they must base the calculation on the age of the oldest beneficiary, who may be the surviving spouse.
An alternative might be to set up two separate IRAs: one naming the spouse the beneficiary and the other the children. This would provide for a surviving spouse, while letting the children use their longer life expectancies for the required distributions.
You can designate a parent, sibling, child, or anyone else as your IRA's beneficiary. After you die, non-spouse beneficiaries can extend the RMD over their own life expectancies. What's more, you can create separate accounts for each beneficiary so that younger ones can take advantage of their smaller distribution requirements.
Naming a trust the beneficiary
You may want to name a trust as your IRA's beneficiary to control post-death distributions, protect heirs from squandering the money, or keep unscrupulous people from taking advantage of loved ones. Your heirs would be the trust beneficiaries and subject to the trust's provisions. After your death, the RMD will be based on the oldest beneficiary's age. If there is a wide age difference between heirs, younger beneficiaries could be forced to accept distributions larger than their actual life expectancies would dictate.
Charities get special tax breaks
Are you looking to leave money to a charity? IRAs are an excellent choice. Since the charity is a tax-exempt entity, it will receive the funds without paying income or estate taxes. Furthermore, it can sell the assets and not pay tax on the profits.
Estate is the last resort
Your estate can become your IRA beneficiary. This usually happens when an account owner fails to name a designated beneficiary or all beneficiaries have predeceased her. In such cases, the account will have to go through the expense and time delay of probate, plus the money will have to be paid out faster than the RMD guidelines for each beneficiary.
IRA beneficiary forms should not be taken lightly. The behind-the-scene details impact your intent. As a precaution, you should regularly review your beneficiary designations. This is especially important whenever there is a change in your personal situation, such as a divorce or death of a primary or contingent beneficiary.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.