Don't let the IRS be the beneficiary of your IRA

When you set up your IRA, or any retirement account for that matter, did you take the time to name beneficiaries?  No?  Then the IRS is the one who stands to benefit.  One of the greatest benefits of an Individual  Retirement Account is its ability to grow tax deferred.  No taxes are due until funds are withdrawn from the account.  And what is a major benefit for you can also be a major benefit for your heirs.   With some simple forward planning you can allow your heirs to decide what is best for them and keep it out the hands of the IRS.  

Setting up beneficiaries on your account is a simple process.   All that is required is the completion of a short form – usually names and contact information.     The biggest decision may be determining who the beneficiaries will be.  There are several groups of beneficiaries; your spouse, individuals other than your spouse, your estate, or no one.   Each one allows the beneficiary certain options on how to handle their inheritance.

Your Spouse as the Primary Beneficiary

If you name your spouse they will basically have three options on what to do with the money.  The first is to cash it in.  This lump sum option has the spouse taking everything out of the account.  There is no 10% early withdrawal penalty even if the spouse was under age 59 ½.  Ordinary income tax, however, on the total amount will be due.  This could present a big tax bill, and if the money is not needed immediately it forgoes the additional benefits of tax deferred growth.    

Your spouse could also choose to rollover the assets into an IRA in their own name.  In this case the assets are treated as if they were the spouse’s from day one.  Any required distributions would then come under the spouse’s life expectancy, which could potentially delay the need to take distributions for years.  For example; a spouse would not be required to take distribution until they reach 70 ½, not when you do.  The downside is that if the inheriting spouse is under age 59 ½ then any distributions taken prior to 59 ½ would be not only subject to income tax but to a 10% early withdrawal penalty as well.   So if some or all of the money is needed right away this may not be the best option.  

Luckily your spouse has a third option, which is to take it as an inherited IRA.  Distributions based upon the surviving spouse’s life expectancy are required with this option and are based upon your age at the time of death.   If you were over the age of 70 ½ when you passed away, distributions by your spouse would need to start the following year.  If not, your spouse’s distributions would need to begin in the year you would have turned 70 ½. This solves the problem noted in the previous paragraph

A Non Spouse as a Beneficiary

If you name someone other than your spouse, such as your children, other relatives, or friends, they also would have three options.  The first is a lump sum payment.  Just like a spouse’s option, the entire account is taken at once with ordinary income tax rates applying but no 10% penalty. 

The second is to utilize the 5 year rule.  This allows your non-spouse beneficiary who was under age 70 ½ to delay distributions for up to 5 years after the date of death.  Funds can be taken out anytime and at any rate during the 5 year period but they must be entirely distributed by the end of the 5th year.  This can be an option for a beneficiary who may need a significant amount of the account immediately or within a short period of time.  With this option income taxes are due as distributions are made but there is no 10% penalty if the beneficiary was under 59 ½.    

The final option is to re-title the account as an Inherited IRA.  This option allows your beneficiary to allow some of the assets to continue to grow tax deferred.  The beneficiary does need to start taking distributions based upon their own life expectancy starting in the year following the date of death. 

Naming Your Estate or Naming No Beneficiary at all

Naming no beneficiary or your estate as beneficiary is basically the same thing.  Your IRA will be distributed according to your will.  This seems like a straightforward solution, but it has one serious drawback.  An estate has no life expectancy and therefore cannot get the same benefits a human beneficiary could.  The estate must make the required minimum distribution under the 5 year rule as noted previously.  The individuals who thus receive the proceeds from the account are denied the benefits of having an option on how they would want to receive the money and give up the ability to keep all or part of your investments growing tax deferred.  Taxes on the IRA withdrawals over that 5 year period will be subject to ordinary income taxes.   This defeats one of the major benefits of IRAs - tax deferred growth.

The only exception to this is if there is a surviving spouse who is the administrator and ONLY beneficiary of the estate.  In this case your spouse can effectively roll the IRA assets into his/her own IRA.   Of course estates with only one beneficiary, the spouse, are not common.

Contingent Beneficiaries

It is always a good idea to name a contingent or backup beneficiary on your account.  You may think you will not outlive your spouse or children, but that is not always the case.  If they pre-decease you and you cannot alter your beneficiary designation in time the search will be on for who should inherit your IRA.  With no living beneficiary the IRA will automatically pass to your estate, with all of the issues we just discussed.  Obviously this can be avoided by the simple task of naming a contingent beneficiary.

The start of a new year is a good time to review your IRA and your beneficiary information.  Taking a few simple steps could greatly benefit those whom you choose to benefit; and keep the IRS away from what you worked hard for your entire life.

Eric is an Investment Advisor and Principal with Berls Asset Management. He specializes in helping individuals and businesses with retirement and financial planning.   Berls Asset Management is a Registered Investment Advisor registered with the State of Illinois.  The firm is fee only and as such it does not take commissions, 3rd party payments, or any other compensation from anyone but our clients.  This puts Berls Asset Management on the same side of the table as the clients it serves.  The firm is independent, owned by its employees, and has no outside forces dictating how it best serves its clients or what solutions we provide.

The firm operates with one underlying objective; to work with a select group of clients to develop very specific goals for the attainment and protection of wealth.  

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