If You Have Heirs, It Is Important To Know The Difference
In order to avoid a sizable tax bill on an inherited IRA, you can take advantage of a “stretch” IRA, which extends required distributions on an inherited IRA. To do this, you name your heirs instead of your spouse as the IRA’s beneficiary. However, taking care of your spouse is a priority. If you do not have sufficient assets outside the IRA to maintain your spouse, then your spouse should be the primary beneficiary of your IRA. If that is not the case, you need to be sure to name your heirs as designated beneficiaries (not just a beneficiary), so you can help avoid costly mistakes. Learn what the difference is and why it matters.
An individual or legal entity (such as a charity or estate) can be a beneficiary that inherits an IRA. However, a designated beneficiary can only be a living person who is named on the IRA beneficiary form. Two great reasons to use a designated beneficiary are:
- The distributions from inherited IRAs can be stretched over the lifetime of the designated beneficiary, which could allow for possibly decades of tax-deferred investment returns.
- Probate is bypassed as the IRA passes directly to a designated beneficiary.
For example, Matthew (age 72) named his estate as the beneficiary on his IRA beneficiary form. However, his will instructs that the IRA proceeds should be distributed to his grandson, Jack, who is age 22 when Matthew dies.
According to the tax code, since the estate is not a designated beneficiary, the IRA must be paid out to the estate over a period determined by whether or not Matthew had reached his required beginning date (RBD), which is age 70 ½, for taking annual required minimum distributions when he died.
If Matthew hadn’t reached his RBD, then the IRA balance must be paid out in five years. Since Matthew has reached his RBD, the IRA will be paid out over his projected life expectancy with a maximum of 15 years.
On the other hand, if Jack had been named the designated beneficiary, the IRA would be paid to Jack over his own life expectancy of 61 years! This could result in a huge future tax-favored payoff.
Naming a designated beneficiary can mean the difference between a 5-to-15 year IRA payout and one that might last several decades.
The Pain of Probate
If an IRA is left to an estate, it is then considered an asset and must pass through probate, which means:
- Since probate a legal process, it can take a long time.
- Probate costs money, which could be a percentage of the probate assets.
- There is no privacy as wills are public documents and probate is a public process.
- Someone challenge the will and the recipients of the IRA funds.
Unfortunately, a will could be lost or obsolete as people don’t always keep on top of updating their wills. This could mean that the IRA may not be distributed as hoped. It is much easier, and better in the long run, to name the IRA beneficiary on the IRA beneficiary form to avoid all of these issues. These are simple forms that can be updated at any time.
So even if a beneficiary decides not to use the stretch IRA benefit and cashes in the IRA immediately, naming a person as the designated beneficiary is still the best route.
The Deal With More Than One Beneficiary
If multiple beneficiaries are named on an IRA, it shortens the amount of the stretch period for all of them. So if Larry, age 45, is a beneficiary along with Jack, the stretch period for both of them would be 38.8 years, the remainder of Larry’s life expectancy. Jack then loses about 22 years of stretch.
Charities and estates don’t have a life expectancy. So if either is named as a beneficiary of an IRA, the actual human beneficiaries, such as Larry and Jack, would not be entitled to any stretch.
To solve this, the IRA can be split. In the year after an owner of an IRA dies, estates or charities can cash out of the IRA by September 30, leaving the individual beneficiaries as designated beneficiaries. The IRA can then be split into their own separate IRAs by December 30, with the stretch of each being based on their own life expectancies.
An IRA can be left to an estate by accident if the beneficiary form is lost, which means the IRA custodian pays the IRA to the estate by default. Whether intentional or unintentional, it typically is not recommended to leave your IRA to an estate. Use and update IRA beneficiary forms regularly, which will name and protect your designated beneficiaries – especially if you have heirs.
As always, when dealing with estate issues, consult your estate tax attorney for the best advice for your particular situation.
By Paul McEwan CPA, MTax, AIFA (New Philadelphia)