Naming an IRA Beneficiary

By Tamara Polley

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What happens to your Individual Retirement Account when you die, and how will that impact your heirs?

Distributions from an IRA are taxable to the recipient just as they would have been to the original owner. However, it’s important that IRAs are properly titled to allow beneficiaries to “stretch” payout – thus reducing or delaying income taxes on the money.

When you establish an IRA, you fill out a beneficiary designation form specifying who is to receive the account balance upon your death. Because this completed form takes precedence over the provisions of a will or trust, you should carefully review IRA designations during estate planning.

You should also revise those designations in certain situations – if you get divorced, for example, or if a planned beneficiary dies.

In cases where no beneficiary is named, the estate becomes the beneficiary by default. If assets exceed $150,000, a probate proceeding – typically cumbersome, lengthy and expensive – may be required in order for funds to be distributed. Generally, the IRA must be cashed out immediately, and income tax is due on the entire sum.

Likewise, some people name their estate as beneficiary, which is usually not the best choice as it can result in the same lengthy probate process.

When designating a beneficiary, here are four options to consider:

A Spouse: The IRS gives spouses more options for payout than any other beneficiaries. Spouses can treat the IRA as their own and put it in their own name, or can roll it over into a new IRA. With either option, a spouse is not required to withdraw from the account until age 70 ½.

A third option is to re-title the account as an “inherited IRA.” If the spouse is under age 59 ½ , this will allow him or her to withdraw funds immediately without paying the 10 percent penalty that normally applies to early IRA distributions. Instead, ordinary income taxes on withdrawals would apply.

One or More Non-Spouse Individuals: Individual beneficiaries who are not spouses cannot treat the IRA as their own or roll the accounts over into new IRAs in their names. However, the beneficiary can re-title the account as an inherited IRA and “stretch” the payout to defer taxes. Again, there is no 10 percent penalty on withdrawals even if the beneficiary is under age 59 ½; rather, withdrawals are subject to ordinary income tax as they are received.

The rate at which a non-spouse beneficiary must make withdrawals depends upon whether the original owner had reached age 70 ½ and had begun making withdrawals before his or her death.

The beneficiary of an inherited IRA can always withdraw more than the minimum payment – determined by annuity tables based on life expectancy – but not less than that amount.

In the case of multiple beneficiaries, each person has the option to choose his or her rate of withdrawal. If one beneficiary does not wish to stretch the payout of his or her portion, that amount may be taken as a lump sum. However, the beneficiary will immediately owe income tax on that amount, losing the advantage of tax deferral.

Trust: An owner can designate a trust as an IRA beneficiary, and at times this is appropriate. For instance, if the owner has a loved one with special needs, it is better to name a “special needs trust” as beneficiary rather than the individual, who may be unable to manage his or her own assets.

To qualify for need-based programs such as SSI, Medi-Cal and Section 8 housing, individuals generally can only have $2,000 in assets. An inheritance of even $10,000 can cause problems and significantly disrupt their life. Because money put into a properly crafted trust is not considered “theirs,” it does not count when determining eligibility for those programs.

However, specific criteria must be met for a stretch payout to be available. If the trust does not meet these criteria, the IRA must be paid out over five years.

Charities: For those who plan to make charitable gifts upon their death, naming a nonprofit organization as an IRA beneficiary can be very advantageous since the nonprofit does not pay income tax.

Take time to review your IRA designations and discuss them with your professional advisors.

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