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The Importance of Designating the Right Beneficiary for an IRA


Does naming a Beneficiary Matter?  Doesn’t it go to my estate anyway?

Yes it matters. IRAs transfers are not covered under your Will, but according to beneficiary designation form that you complete for your IRA account.  This is why it is important to complete a beneficiary form when you set up your account and make sure that it is kept updated. If you die before your required minimum distribution date, your estate is designated as the beneficiary and the IRA must be distributed within a five year period.  If you die on or after your RMD date, distributions generally must be taken over the account owner's remaining single life expectancy (calculated in the year of death according to IRS life expectancy tables, up to a maximum of 17 years. This is a lost opportunity to take advantage of preferable treatment allowed for designated beneficiaries.

Who can I Designate as a Beneficiary?

You can designate any individual as your IRA beneficiary or contingent beneficiary. Under the IRS Required Minimum Distribution (RMD) rules, beneficiaries can “stretch out” RMDs over their own expected life spans. Why is this important? Distributions trigger taxation for a traditional IRA. For a Roth IRA there is no taxation when funds are withdrawn, but the benefit of continued tax free growth continues.  In most cases, the beneficiary is significantly younger, giving many more years of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA.

Can I Designate a Trust as Beneficiary?

Yes, you can also designate a Trust as your beneficiary and there are some good reasons where this might make sense.

There's little to prevent your beneficiary from simply taking a lump-sum distribution upon inheriting the IRA, rather than "stretching out" distributions over his or her life expectancy. In addition, creditors or spouses might be able to go after inherited IRA assets.  In order to protect your beneficiary from their own instant gratification and also from creditors, it's possible to name a trust as the beneficiary of your IRA to establish some control over how distributions will be taken after your death

Normally, when you name an IRA beneficiary that isn't an individual (e.g., a trust, charity, or your estate), that beneficiary must receive the entire balance of your IRA within five years after your death. However, special rules apply to trusts. If specific IRS rules are followed, then the trust beneficiary, and not the trust itself, will be deemed the beneficiary of the IRA, allowing RMDs to be calculated using the trust beneficiary's life expectancy and avoiding the five-year payout rule. Because the IRS looks beyond the trust and treats the trust beneficiary and the IRA beneficiary, this is commonly referred to as a "look-through trust." 

Four requirements must be met for a trust to qualify for look-through treatment:

  • The trust beneficiaries must be individuals clearly identifiable (from the trust document) as designated beneficiaries as of September 30 following the year of your death.
  • The trust must be valid under state law. A trust that would be valid under state law, except for the fact that the trust lacks a trust "corpus" or principal, will qualify.
  • The trust must be irrevocable, or (by its terms) become irrevocable upon the death of the IRA owner or plan participant.
  • The trust document, all amendments, and the list of trust beneficiaries (including contingent and remainder beneficiaries) must generally be provided to the IRA custodian or plan administrator by the October 31 following the year of your death.

 

Multiple Trust Beneficiaries:

It is possible to have multiple trust beneficiaries; however, the life expectancy of the oldest beneficiary will be used to calculate RMDs. Depending on the age of the oldest beneficiary relative to the other beneficiaries, there might be a significant difference in the “stretch out” period. If you want each beneficiary to be able to use his or her own life expectancy to calculate RMDs, then you'll generally need to establish separate trusts for each beneficiary to accomplish that goal. Generally, see-through trusts are structured as "conduit trusts," where all distributions received by the trustee from the IRA must be passed on to your beneficiary.

What if the Trust Doesn’t Qualify for Look Through Treatment?

If the trust doesn’t qualify as a look-through it will still receive the distributions. However, the trust may be required to take the payout within as little as five years if the account owner hadn’t reached April 1 after turning 70 ½ (the required beginning date for taking IRA withdrawals) before he or she died. If the owner died on or after this date withdrawals are calculated according to the account owner’s remaining life expectancy, as if he or she were alive. In most cases, this means a more rapid payout than if the trust could use the life expectancy of its oldest beneficiary to calculate withdrawals.

Spouse as Beneficiary:

Normally, the inheriting spouse can roll over the IRA into his or her own IRA and defer distributions until reaching age 70 ½. When calculating the required minimum distributions, the spouse can use the IRS uniform life expectancy table that applies to IRA owners, rather than the “single life expectancy” table that applies to inheritors; using this table results in smaller required distributions each year. Rolling the IRA over into his or her own IRA also entitles the spouse the option to convert a traditional IRA to a Roth. This option is not available to non-spouse inheritors.

Selecting beneficiaries for your IRA, 401k and other assets should be done as part of a larger estate planning process that should include your accountant, attorney, financial planner and investment advisor.  At AEPG, we prepare an estate planning outline for clients integrated with their financial plan and coordinate with the client’s account for tax planning and with their attorney to draft their Will and other estate documents.

Contact us for a review of your options.

Chris Schiffer 908-821-9764 or email cschiffer@aepg.com   

 

Important Disclosures:

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested.  Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by American Economic Planning Group, Inc. (“AEPG”) will be profitable. Definitions of any indices listed herein are available upon request. Please remember to contact AEPG if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. This article is not a substitute for personalized advice from AEPG and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Investment decisions should always be made based on the investors specific financial needs, objectives, goals, time horizon, and risk tolerance. Please remember to contact AEPG Wealth Strategies if there are any changes in your personal or financial circumstances or investment objectives as these changes may impact our previous recommendations.  This information is current only as of the date on which it was sent.  The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of AEPG.  Descriptions of AEPG’s process and strategies are based on general practice and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.

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