IRAs can be left to spouses, children or other heirs upon your death. These accounts are often a significant part of your net worth, so it’s important to know the rules surrounding passing your IRA on to your heirs so that you can plan accordingly.
IRA accounts, both Roth and traditional, pass by beneficiary designation. Always be sure this is correct and up to date—regardless of your intentions or what your will might say, the beneficiary designation determines who inherits the account. If you get married, divorced or experience other relevant life changes you will want to be sure the designations are current, up-to-date and that they reflect your wishes.
You can generally have a primary beneficiary and a secondary beneficiary. There can be more than one of each and you'll generally need to specify the percentage of the account going to each beneficiary listed.
Beneficiaries generally have two options when inheriting a traditional IRA:
They can take a distribution of the entire account balance within five years. The distributions will be taxed, but there will be no penalties regardless of the beneficiary’s age. This option is allowed if the deceased had not reached age 70 ½ by the time of their death and was not taking required minimum distributions.
The heirs can also “stretch” the IRA by electing to open an inherited IRA. If the deceased was taking required minimum distributions at the time of their death and had not taken their RMD in their year they died, then the heirs will need to take a distribution for that year. Otherwise they can wait until December 31 of the year following the death of the original owner to begin taking distributions. Annual distributions are taken using a life expectancy calculation based on the IRS tables for the longer of their life expectancy or the life expectancy of the deceased. The advantage is that for younger beneficiaries, the amount of the annual distribution will be based on their age allowing them to stretch the tax-deferral of the account for many years.
This allows the beneficiary to keep the account intact and growing on a tax-deferred basis. It’s important to know that an inherited IRA account cannot be co-mingled with any other IRA account the beneficiary might own.
Roth IRA beneficiaries can take distributions from the account tax-free as long as the deceased had established a Roth account at least five years prior to their death.
A spouse can inherit an IRA and treat the account as his/her own, both traditional or Roth. If they already have an IRA, they are free to combine the accounts into one. The timing of required minimum distributions (RMDs) will be based upon their age, not the age of the deceased spouse. If the deceased spouse had begun taking their RMD, but the surviving spouse is younger than age 70 ½ then he or she can delay RMDs on this money until they reach age 70 ½.
If the surviving spouse rolls the inherited IRA money into their own IRA and they are under age 59 ½, they will incur a penalty on any withdrawals prior to reach age 59 ½.
If the surviving spouse is under age 59 ½ and will need to access the money, it may make sense to move the money from your deceased spouse’s IRA to an inherited IRA. This allows the surviving spouse the option of using the five-year rule described above if the deceased spouse had not yet begun taking their RMDs. If RMDs had commenced, then the surviving spouse can take annual distributions based on their own life expectancy. In both instances, distributions would be taxed, but not subject to penalties.
Disclaiming all or part of an IRA
Spouses and non-spousal beneficiaries may opt to disclaim all or part of an inherited IRA account. In this case, the disclaimed portion will go to the deceased’s contingent beneficiaries.
An inheriting spouse may opt to do this if they don’t need the money and wish to give that money to the contingent beneficiaries who might be their children or grandchildren. Non-spousal beneficiaries might also consider this for similar reasons.
Trusts as beneficiaries
Beyond leaving your IRA to a person as the beneficiary, you can also designate a trust as the beneficiary. This can be a bit more complicated than naming an individual as the beneficiary, but can make sense under certain circumstances. Reasons to use a trust as the beneficiary include:
- To protect a beneficiary who is a spendthrift from squandering the money. The provisions of the trust can designation when and how much the beneficiaries of the trust will receive.
- To provide for children from a prior marriage.
- To provide for minor children.
You'll also want to make sure that any transfer from the deceased’s IRA to an inherited IRA or to the surviving spouse’s account is done directly. If the account of the deceased was with another custodian, be sure to do a trustee-to-trustee transfer. If the account was with the same custodian be sure to do a direct account to account transfer.
An IRA is often one of our most significant assets. Careful planning is needed to ensure the account passes to our heirs in the desired manner and without your heirs taking a tax hit in the process. It's critical to be sure that beneficiary designations are current and reflect the proper beneficiaries, so be sure to consult with your financial advisor to make sure you're not missing anything in this process.