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Understanding the Impact of Beneficiary Designations and IRA Rules

Beneficiary designations are a crucial step when it comes to smart estate planning. Naming a primary beneficiary on your IRA is often considered the most important designation, as this party would be the first in line to receive your IRA assets. However, contingent beneficiaries are also crucial because they would receive your IRA assets if none of your primary beneficiaries survive you, or in the situation where a primary beneficiary disclaims the IRA assets.

A beneficiary may disclaim all or a portion of an inherited IRA benefit. By disclaiming, the beneficiary is giving up rights to the IRA assets, which then pass to the other beneficiaries. There are specific requirements that a valid disclaimer must meet, and it’s generally required to be executed within nine months of the account owner’s death.

Designated Beneficiaries

For IRA distribution purposes, beneficiary designations do not become fixed until September 30th of the year following the year of an account owner’s death. For obvious reasons, new beneficiaries cannot be named after the death of an account owner. However, beneficiaries that disclaim or have had their benefits paid out to them in full prior to this date, will not be considered when determining death distribution options.

Spouse Beneficiary

Married account owners usually name their spouse as beneficiary of their IRA. When a spouse is the sole primary beneficiary of an IRA, he or she can choose to take ownership of the IRA by transferring it into an IRA in his or her own name. This gives a spouse the right to name his or her own beneficiaries. It also allows the delay of distributions until age 70½ and can potentially allow for additional IRA contributions to be made. However, the IRA would be subject to all Traditional IRA rules, including the additional 10% penalty for distributions taken prior to attaining age 59½.

A spouse beneficiary also has the right to leave inherited IRA assets in a “decedent” status and is not required to begin taking required minimum distributions until the original owner would have reached age 70½. If a surviving spouse is under age 59½ at the time of inheritance, this could be an appealing option. 

Non-spouse Beneficiaries

If non-spouse individuals are named as beneficiaries each would be required to take distributions over his or her single life expectancy. A separate account for each beneficiary would need to be established and distributions are required to begin by December 31st of the year following the year of death.

“Stretching” distributions over a beneficiary’s life expectancy keeps the assets growing tax-deferred and can result in significant accumulation over a beneficiary’s lifetime. A beneficiary has the right to take more than the minimum in any given year, including the right to take a complete distribution. All distributions would be taxed at a beneficiary’s ordinary income tax rate and would not be subject to the 10% premature distribution penalty, regardless of the beneficiary’s age.

Upon inheriting an IRA, a beneficiary can name subsequent beneficiaries. If a beneficiary dies before the assets are fully distributed, the subsequent beneficiary may take a lump sum distribution of the IRA assets or may choose to maximize tax-deferral and growth by continuing to take distributions over the remaining life expectancy of the original beneficiary.

When designating non-spouse beneficiaries, there are two methods available for distributing the IRA assets if one of the beneficiaries precedes you in death. Let’s review these two options:

  • Your IRA assets are divided among the surviving beneficiaries only, with no representation by the descendants of the deceased beneficiary.
  • Per stirpes designation, which means “by the branch in equal shares.” If a beneficiary predeceases an account owner, that beneficiary’s share goes to his or her lineal descendants. The descendants would not need to be individually named on the beneficiary form. This can be an advantage if the beneficiaries are young and are still having children. The beneficiary forms would not need to be updated each time a child is born.

Estates, Organizations and Trusts as Beneficiaries

Entities may be entitled to IRA proceeds as beneficiaries, but they cannot be considered “Designated Beneficiaries” because they are not people and therefore, do not have a life expectancy. If one of these entities is listed as the IRA beneficiary and an account owner dies before he or she was required to begin taking minimum distributions from an IRA, (April 1st of the year following the year an account owner turns 70½) the IRA must be distributed within five years. If death occurs after an account owner was required to begin taking minimum distributions, the IRA must be distributed to the beneficiaries over the account owner’s remaining single life expectancy.

Estate

Leaving your IRA to your estate has an additional disadvantage of subjecting the IRA assets to probate. Probate can be expensive, time consuming and make your assets inaccessible for a period of time. In addition, probate is a matter of public record. Even if your spouse or children are the heirs of your estate, they will not have the same distribution options available to them as they would otherwise have if they had been the named beneficiary(ies) of your IRA. Being forced to withdraw the money at a faster rate could create a tax disadvantage for a beneficiary who would have kept the assets growing in an IRA on a tax-deferred basis. 

Organization

Naming a charity as beneficiary will remove the IRA assets from your taxable estate for estate tax purposes. In addition, neither your estate nor your heirs would be subject to income taxes on the amount the charity receives. If a charity or an estate is a beneficiary of only a portion of the IRA, the other beneficiary(ies) of the IRA may be the “Designated Beneficiary” if, by September 30th of the year following the year of the IRA owner’s death:

  • The charity or estate cashes out its share of the IRA; or
  • The IRA is divided into separate accounts for each beneficiary.

Trust

A trust as beneficiary can be a useful estate-planning tool if properly structured. A trust as the beneficiary, can provide control over how IRA assets are managed and distributed after an account owner’s death. Even though a trust is a non-living entity, a special rule may be applied to trusts. Under this rule, the oldest person who is a trust beneficiary will be treated as the “Designated Beneficiary” if the following requirements are met:

  • The trust is valid under state law and is irrevocable or will, by its terms, become irrevocable upon the death of the IRA owner;
  • The trust beneficiaries must be individuals clearly identifiable (from the trust document) as “Designated Beneficiaries” as of September 30th following the year of the IRA owner’s death;
  • The IRA custodian is provided with a list of beneficiaries (including contingent and remainder beneficiaries) along with a certification that the list is accurate and the trust is a valid “look through” trust by meeting the above requirements, by October 31st of the year following the year of the IRA owner’s death; and
  • A copy of the trust instrument is provided to the IRA custodian upon demand.

Conclusion

Your beneficiary designation can have a significant impact on your IRA’s ability to sustain its tax advantaged status over the long run. It is important to periodically review your beneficiary designations to ensure that they meet your wealth planning objectives. You should discuss your IRA beneficiary designations with your financial advisor, or your tax, estate planning or legal professional to maximize the benefits of your IRA for you and your beneficiaries.

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Founded in 2008, STRATA Trust Company has built a reputation delivering streamlined and straightforward custody. Our service-driven team has helped thousands of investors and investment professionals unlock opportunities in self-directed retirement accounts across a wide range of alternative investments. Formerly known as Self Directed IRA Services, Inc., STRATA has strategically realigned to support a broad range of investment professional partners in growing their IRA asset base – always with an eye on the future.

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