How to Select IRA Beneficiaries
Naming a beneficiary on an IRA account is the estate plan for IRAs. Estate planning for IRAs cannot be done through a will. It is most important to name a beneficiary. It preserves the “stretch” IRA and spreads payments over the life expectancy of the beneficiary. It prevents the imposition of the five-year rule in a case where the IRA owner dies before the required beginning date (RBD), April 1st of the year following the year the IRA owner turns 70 ½. It prevents the IRA from having to be probated. There are strategies to be employed in selecting a beneficiary. The purpose of this article is to explore those.
The Choices
There is an important distinction between a beneficiary and a designated beneficiary. A designated beneficiary is a living person with a birth date. A beneficiary is a nonliving entity such as an estate or a charity. The latter have no life; therefore they have no life expectancy. If an IRA owner dies before the RBD and the estate is the named beneficiary, the IRA must be completely distributed by the end of the 5th year starting with the year after death. If an IRA owner dies after the RBD, the distributions are stretched over the IRA owner’s remaining life expectancy. Not bad, but it could be better if there was a designated beneficiary and that designated beneficiary was a child or a grandchild.
The designated beneficiary choices that spread the IRA required minimum distributions (RMDs) over the longest period are the living spouse and the children. Choosing an older designated beneficiary, a trust for the surviving spouse, and the estate are not tax-wise choices. The older beneficiary has a shorter life expectancy and therefore higher RMDs. The trust is subject to accelerated marginal tax rates. The estate is not a designated beneficiary. Therefore, RMDs will be high for an estate because of either the 5 year rule or the IRA owner’s life expectancy.
The Surviving Spouse as Designated Beneficiary
When the surviving spouse inherits the IRA, she has two choices (let’s assume it’s a “she” for purposes of this article). She may treat the IRA as an inherited IRA, keeping it in name of her deceased husband i.e. John Doe IRA (deceased 12/25/2008) F/B/O Jane Doe, beneficiary. She might choose this route if she is under 59 ½ and wants to avoid the 10% premature distribution penalty which would be incurred if she rolled the inherited IRA over into her own account.
If the spouse is over 59 1/2, she has two choices. She can roll the inherited IRA into her own IRA, treat it as her own IRA using her own life expectancy, and take distributions if she needs them. Otherwise, she can wait until her RBD, April 1st of the year following the year she attains age 70 ½. Or, she can leave the IRA in her husband’s name and put off distributions until December 31 of the year her husband would have attained age 70 ½, had he lived. She can also take distributions immediately from the inherited account, without incurring the 10% premature distribution penalty, because she is over 59 1/2.
If she was older than her husband…let’s say she was 74 and he was 65 at date of death…leaving the IRA in her husband’s name as an inherited IRA would stretch the IRA further by using his life expectancy. This works whether she needs the money or not. The RMDs will be smaller, whether she takes distributions immediately or waits until his RBD.
If she is under 59 ½, then if she wants to have distributions start immediately, she must rename the account as an inherited account (see first paragraph under this heading above). Otherwise, if she rolls his account into her own IRA and starts taking immediate distributions, they will be subject to the 10% premature distribution penalty.
A surviving spouse who chooses to use an inherited IRA account and start distributions must use the Single Life Table, which does not give the better spread. The Uniform Life Table does give the longer spread. However, there is an exception which gives a little relief in terms of a longer spread. If the surviving spouse is more than 10 years younger than the deceased spouse, she will use the Joint Life Table to compute the new life expectancy, even though the other spouse died. This benefits the surviving spouse because the life expectancy factor is longer under the Joint Life Table, resulting in a lower required distribution.
Just because there are rules to assist in computing the RMD does not mean the surviving spouse cannot take more than the RMD. She can, and if there is need, she should take what is necessary to meet her needs.
Where there are both traditional IRAs and ROTH IRAs, the question arises as to which accounts should go to the spouse and which should go to children or other low income beneficiaries. In most cases, the ROTHs should go to the high income beneficiaries for two reasons: 1) they are nontaxable, and 2) there are no RMDs when a ROTH is passed to a surviving spouse. That keeps the stretch-compounding of earnings going for a longer period.
The Surviving Minor Children as Designated Beneficiaries
There are four basic methods of how to choose a minor child as a designated beneficiary: 1) the named minor child, 2) a custodian of a Uniform Transfer to Minors Act (UTMA) account, 3) a Conduit Trust, and 4) an Accumulation Trust, of which there are two types.
Leaving any asset, including an IRA account, to a minor child outright is generally not a good idea. In fact, some plan administrators may not release the funds to anyone but a guardian of the minor child.
Leaving the IRA account to a custodian of an UTMA account is better, although IRS has not ruled specifically on this transfer per se, but they have ruled that income paid to a custodian is taxable to the minor.
Naming a Conduit Trust as the designated beneficiary is an even better solution, provided the account is large enough to cover the trustee fees and still yield a decent after-expense return. Think about $100,000 or more as the cutoff point to recommend a Conduit Trust arrangement. The trustee distributes the RMDs each year to an UTMA account, leaving the trust with little or not income to be taxed. However, the trustee could distribute more or less than the RMD, in his or her discretion.
Naming an Accumulation Trust as the designated beneficiary allows a trustee to use principal and/or income as is advisable for some or all minor children, giving the trustee to right to accumulate or distribute up until a certain age, such as age 25, age 30, or age 35, for example. At that time the principal would be distributed to the adult child. The trust language should provide that it qualifies as a “Conduit” trust if the trustee wants to use a life expectancy payout.
The Credit Shelter Trust as a Designated Beneficiary
The federal estate tax allows a credit against the estate tax on up to $3,000,000 of assets left to someone other than a spouse or charity. Massachusetts allows a credit against the state “sponge” tax on up to $1,000,000 of assets left to someone other than a spouse or charity. It is basic estate planning to be sure that full advantage is taken of the allowable credits. For wealthy families, it makes sense to use a trust to take advantage of the benefits the estate tax law allows. Such a trust names the children, typically, as principal beneficiaries and the surviving spouse as the life income beneficiary. The trust is known by the name “credit shelter trust” or “bypass trust” because the value of the trust is not taxed to the estate of the surviving spouse when he or she dies. It bypasses the surviving spouse’s estate because he or she has no right to the principal, other than a so-called “5 and 5” rule.
The problem with the credit shelter trust is it is not known until the death of the first-to-die spouse whether there are enough assets to fund the trust without depriving the surviving spouse of needed income and assets, should she need them. It is nice to save estate taxes, but not at the expense of a lowered lifestyle for the surviving spouse. An estate with substantial IRAs and other retirement accounts poses liquidity problems as well.
The time-tested solution for wealthy families but it is uncertain whether the spouse will need some income is to set up the credit shelter trust and name it as a contingent beneficiary. Then, after the death of the first-to-die spouse, the attorneys, accountants, and planners can decide whether and how much to fund the trust. If the decision is made to fund the trust, the surviving spouse would disclaim her share of the IRA(s) as a primary beneficiary, leaving the trust to be funded as contingent beneficiary.
If there is no problem in determining whether there will be enough assets to fund the trust, the trust can be named as the primary beneficiary. Also, IRA accounts can be split in such a way as to reduce somewhat the uncertainity of how much the credit shelter trust will receive.
The credit shelter trust can have the Conduit Trust language added so that the high tax rates applicable to taxable income of trusts can be avoided. Thus, the income from the required minimum distributions will flow through the trust to the beneficiary’s tax return.
Obviously, if the IRA were a ROTH, the tax consequences would be nil because the tax would have been paid upon conversion or never if the ROTH was a ROTH from the beginning.
Naming Qualified Charities as IRA Beneficiaries
Naming a qualified charity as an IRA beneficiary eliminates both estate and income taxes. It makes sense only if the IRA is a surplus asset or there was a donative intent and there was choice over what assets to use. Generally, only the wealthy can afford to give away significant monies, and IRA accounts are one the best vehicles to use.
There are some mistakes that can be made in this area.
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