Selecting the Right Beneficiary for Your IRA
Presented by Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC®:
Not only are IRAs an excellent way to save for your retirement, but they can also serve as a vehicle to pass along assets to your loved ones. As an IRA owner, you have choices to make regarding your account, including which vendor to use, what investments to make, and how much to contribute each year. One of the most important decisions you will have to make, however, is whom to designate as your beneficiary. The options vary and can include a spouse, nonspouse, or entity, such as an estate or trust. Here, we’ll cover the various types and the most important factors to consider when choosing your beneficiary.
What are the rules when a spouse inherits an IRA?
When it comes to inheriting IRAs, spouses have the most options and flexibility, which makes this beneficiary designation appealing. The following distribution options are available only to spouses:
Treating the assets as his or her own
- A spouse beneficiary can transfer the assets to a traditional IRA in his or her own name. Required minimum distributions (RMDs) will begin the year in which the spouse turns 70½. If the spouse is younger than the original account owner, this will allow the spouse to delay taking RMDs, providing more years of tax-deferred growth.
- If a spouse inherits a Roth IRA, RMDs are not required, which may provide additional years of tax-free growth. This option could greatly benefit the spouse’s beneficiaries (e.g., children) as well.
Placing assets in an inherited IRA
- In this scenario, RMDs would generally begin the year after the original account owner’s death. For a sole spouse beneficiary, however, he or she can choose to defer RMDs until the year in which the decedent would have turned 70½. In cases where the spouse is significantly older than the original account owner, this would be beneficial, as the spouse might be able to delay taking RMDs from the account for some time.
- A spouse can also use the inherited IRA option to his or her advantage if he or she is younger than 59½ and needs the money now. Distributions from an inherited IRA are not subject to the 10-percent premature withdrawal penalty, whereas the penalty would apply if the spouse treated the assets as his or her own.
With such flexible options and the likelihood that your spouse will handle your finances after you pass, a spouse beneficiary may be the best choice. But there are some questions to ask yourself first. Does your spouse need the money? If you and your spouse are well off, perhaps naming your children as primary beneficiaries would be best, as they could take direct possession of the funds and potentially stretch RMD payments over a longer period. Or, do you have children from a previous marriage? To ensure all your intended beneficiaries get their share of the IRA assets, it may be best to name a spouse and children or just the children as primary beneficiaries.
What are the options for nonspouse beneficiaries of inherited IRAs?
Unlike spouses, nonspouse beneficiaries only have the option of opening an inherited IRA to receive the assets, and their RMDs must begin the year following the IRA owner’s death. Any individual may be named a nonspouse beneficiary, but aside from a spouse, children are the most commonly designated beneficiaries. If you’re contemplating naming your children as beneficiaries, ask yourself the following questions:
How old are your children? Are any of them minors? The younger the child, the longer the RMD payments can be stretched, as the child’s life expectancy will be used for the calculation of the payments. But, if your child is a minor, a custodian will have control of the account and will make all decisions regarding that account until your child reaches the state’s legal age of majority.
If you intend on naming multiple children, what percentage should each receive? Should any children be excluded? In most scenarios, IRA owners look to split the IRA assets equally among all their children. But do you have one child who is more financially stable than another? Or do you know if one of your children may not want to receive any assets at all? These are certainly issues to consider.
Are your children financially responsible? Would assets be better left to a trust? In general, naming a nonspouse beneficiary directly offers better distribution options. But if a child is not responsible enough to handle the funds, naming a trust, with a trustee, may be a more appropriate choice. Keep in mind, though, that RMD payments will be based off the age of the oldest trust beneficiary. We’ll go into further details on how that can benefit or hinder your trust beneficiaries in the next section.
Nonindividual beneficiaries: Trusts and estates
Naming a trust as your direct beneficiary results in limited distribution options, but it may be the best choice if you want to leave your assets to your children (or any nonspouse individuals), but do not believe they would be able to manage the money themselves.
Selecting a trust as your beneficiary choice
For example, your teenage child may not understand the full potential of having an inherited IRA and may spend the money all at once. By leaving the funds to a trust, you allow a trustee to execute your wishes for distributing the money accordingly.
There are two types of trusts: qualified and nonqualified (also known as look-through and non-look-through). Only an attorney or qualified legal/financial expert should confirm the type of trust you have. If the trust is determined to be qualified, the trust beneficiary can stretch RMD payments using the oldest trust beneficiary’s date of birth. In a scenario with multiple trust beneficiaries (generally multiple children), this may not be the best way to prolong your IRA. The trust would have to use the oldest beneficiary’s life expectancy, which would result in higher payments. If your trust has a single beneficiary (perhaps an only child), however, it will have the benefit of using one beneficiary’s life expectancy, with the trustee acting on his or her behalf.
The rules for nonqualified trust beneficiaries are generally the same as for other nonindividual beneficiaries, such as estate beneficiaries, which are explained below.
Selecting an estate as your beneficiary choice
In most cases, naming an estate is the least beneficial option, as it offers the fewest distribution options, especially if there are individuals who would benefit from being named directly. More important, if an IRA is left to an estate, the probate court may consider the account as an asset of the estate, and it could be subject to creditor claims.
The biggest downside to naming both estate and nonqualified trust beneficiaries is that, depending on the original account owner’s age at death, either RMDs must be based on that individual’s life expectancy, or the account must be depleted within five years of the owner’s death. This would likely result in larger payments than if a younger beneficiary had been named directly. It would also diminish the chances for additional tax-deferred growth and potentially result in higher tax consequences for the beneficiary in the year of distribution.
The consequences of making an uninformed decision when naming IRA beneficiaries are many and far reaching. Be sure to weigh your options and consult with both your attorney and financial professional before moving forward.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
Kris Maksimovich is a financial advisor located at Global Wealth Advisors 4400 State Hwy 121, Ste. 200, Lewisville, TX 75056. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (972) 930-1238 or at firstname.lastname@example.org.
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