As we have often said, how can something that should be so simple be so complicated?
James Terwilliger, CFP®, is vice president, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at firstname.lastname@example.org.
Case in point – inheriting an IRA from a spouse or other relative.
Improper handling of an IRA after a death can result in the inability of intended beneficiaries to stretch the IRA out over their expected lifetimes. Not keeping beneficiary designations up to date can yield the same undesired consequence.
Beneficiaries – It is critical for the IRA owner to name at least one primary beneficiary. Naming of a contingent and even a third-level beneficiary will allow the IRA to pass to others in the event the primary (and contingent) beneficiary predeceases the IRA owner. This needs to be coordinated with one’s will so that the two are consistent and reflect the IRA owner’s wishes.
Designated Beneficiaries – According to the IRS, only designated beneficiaries are allowed to receive post-death distributions over their expected lifetimes. Only individuals, or carefully-designed trusts, may qualify as designated beneficiaries. Charities and estates are not considered designated beneficiaries.
Non-Spouse Beneficiary – A non-spouse beneficiary receives an inherited IRA. This IRA is not owned by the beneficiary, however, and may not be rolled over to a traditional IRA or converted to a Roth IRA. Generally, the beneficiary must start receiving required minimum distributions (RMDs) beginning the year following the death of the IRA owner unless the beneficiary chooses to liquidate the account within 5 years. The distribution rate is dictated by the life expectancy listed in the IRS Single Life Table. If the IRA owner dies on or after the required beginning date, more distribution choices are available.
The beneficiary can name follow-on beneficiaries, but the term cannot extend beyond the initial term.
Spouse Beneficiary – While a spouse can follow a similar approach, a spouse has another, more-favorable option – to roll the inherited IRA over to his or her own IRA. This allows the spouse to waive RMDs until age 70-1/2, use a less-aggressive distribution schedule which can stretch the IRA through the spouse’s full lifetime (vs. a fixed-number-of-years expected lifetime), combine with other IRAs, and convert to a Roth IRA if desired.
Estate as Beneficiary - One should avoid leaving an IRA to an estate. Doing so generally requires the estate to liquidate the IRA and pay associated income taxes at much-higher estate income tax rates vs. individual rates. This happens when the estate is named as the beneficiary or when there is no beneficiary named. Once liquidated, the reduced post-tax proceeds then pass to heirs according to the will.
Why would someone not name a beneficiary? Sometimes this is a result of neglect on the part of the IRA owner. Other times it is misguided thinking that a will directs IRA distributions. Wrong! The will plays no part. Beneficiary designations trump the will.
Charity as Beneficiary (good) – For IRA owners having both family and charitable interests in their estate plans, it is far more tax-efficient to leave pre-tax IRA assets to a charity and other, after-tax assets to family, given that the charity pays no income tax and the latter generally is income-tax-free to heirs. Most folks, however, do just the opposite – leave taxable IRAs to family and cash to charity.
Charity as Beneficiary (bad) - If a decedent names both individuals and a charity in the same level in the beneficiary hierarchy, because a charity is not a designated beneficiary, inclusion of the charity precludes individual heirs from stretching the IRA over their expected lifetimes. This “defect” can be corrected, however, if the executor takes appropriate action (see below).
Multiple Beneficiaries – Segregating the IRA into separate shares by December 31 of the year following death allows each beneficiary to use his or her own life expectancy to calculate RMDs. It also allows the unbundling of designated and undesignated beneficiaries so that the former can use their life expectancies for distributions and the latter (charities, for example) can receive and liquidate their shares. If not unbundled, the designated (individual) beneficiaries would be forced to liquidate before they might desire.
The estate executor plays the major role here to separate the shares and protect the interests of the designated beneficiaries.
Your Plan - Working with a competent, trusted personal financial planner is the key to ensure that your plan for transferring IRAs to heirs is well-designed and fulfills your wishes.
This material is provided for general information purposes only and is not a recommendation or solicitation to buy or sell any particular security, product or service. Past performance is not indicative of future investment results. Any investment involves potential risk, including potential loss of capital. Before making any investment decision, please consult your legal, tax and financial advisors. Non-deposit investment products are not bank deposits and are not insured or guaranteed by Canandaigua National Bank & Trust, or any federal or state government or agency and are subject to investment risks, including possible loss of principal amount invested.