There are many considerations in deciding who the beneficiary of an IRA should be. This article briefly explains some (though not all) of the options to consider. These concepts can apply to Traditional IRAs or Roths, and can also be a basis for considering 401(k) and 403(b) designations, but each of these accounts has different tax implications.
When the owner of a retirement account (the Participant) dies, the account distributes to the beneficiary(ies) of record. The beneficiary(ies) then have the duty to take distributions at the proper time(s) and pay income tax on the money distributed. Tax-deferred retirement plan distributions are taxed like W-2 wages in the year they are received by the beneficiary. For Roth arrangements, distributions will generally be tax-free if the Roth IRA is more than five years old.
NAMING A SPOUSE AS A BENEFICIARY
For married couples, it is common that the spouse is individually named as beneficiary of an IRA. Estate and income tax laws often favor naming the Participant’s spouse as beneficiary. One of the benefits of naming a spouse is that your spouse can roll over the IRA to his or her name, and then choose a new beneficiary (usually a child or children). This type of rollover is only available to spouses.
However, in choosing your spouse as beneficiary, he or she will have full control of the IRA assets after your death and will be under no obligation to follow your wishes. This may not be what you wanted, especially if there are children from a previous marriage or there are concerns that your spouse may be too easily influenced by others after you are gone.
Any time you name an individual as your IRA beneficiary, you lose control over how the assets will be used. After your death, your beneficiary can do whatever he/she wants with this money, including cashing out the full balance of the account and destroying your careful plans for long-term, tax-deferred growth. The money could also be available to the beneficiary’s creditors, spouses, and ex-spouses. If any of this concerns you, using a trust might make more sense.
NAMING CHILDREN, GRANDCHILDREN, OR OTHERS AS BENEFICIARIES
If your spouse will have plenty of assets after you die, or if you believe your spouse will die before you, or if you are not married, you might consider naming your children, grandchildren, or other individuals as beneficiary(ies).
Previously, this would let a beneficiary stretch distributions out using his/her life expectancy. Under the SECURE Act of 2021, this changed significantly: all non-spouse beneficiaries must completely distribute an inherited IRA within 10 years* of the owner’s death and must meet required distribution minimums in the interim. From an estate planning point of view, this is much less attractive than it used to be.
Beware of naming minors as beneficiaries. While they are eligible to receive the money, they may not have the desired maturity to handle the gift until a later time. Maine’s Uniform Transfer to Minors Act (UTMA) may be a solution, or a trust may be an option, if outright inheritance seems unwise.
NAMING YOUR ESTATE AS BENEFICIARY
It is tempting to name “My Estate” as an IRA beneficiary since ultimate distribution will match what is in your will and you won’t ever have to think about updating it again. However, it is generally not desirable. It can cause unintended tax outcomes for Traditional IRAs because if the IRA distributes to the Estate first, the Estate will have to pay taxes on that distribution, which is generally a higher amount than individual people would have to pay. An estate is an entity and reaches a higher tax bracket more quickly than an individual.
Furthermore, IRAs are often assets that pass outside of the probate process, but if you name your estate as beneficiary, the IRA becomes governed by probate distribution rules and may be spent down by estate expenses or not available for distribution until estate administration is complete.
NAMING A TRUST AS BENEFICIARY
Naming a trust as your beneficiary will give you maximum control after death. That’s because the distributions will be paid not to an individual, but into a trust that contains your written instructions stating who will receive the money, how, and when.
For example, your trust could provide income to your surviving spouse for as long as he or she lives. Then, after your spouse dies, the income could go to someone else. The trust could even provide periodic income to your children or grandchildren, keeping the rest safe from irresponsible spending and/or creditors.
Unfortunately, the “stretch” provisions mentioned above that used to be in effect went away with the SECURE Act, so the IRA will have to be fully distributed to the trust 10 years* after death. During that time, depending on the terms of the document, the trustee may be able to decide how much should be distributed to the beneficiary each year, allowing oversight and management of the money over a longer period of time.
NAMING A CHARITY AS BENEFICIARY OF YOUR IRA
If you are planning to leave assets to charity after you die, a tax-deferred account can be an ideal one to use. The charity will pay no income taxes when it receives the money, and the account will not be included in your taxable estate when you die, which would reduce the amount your family may have to pay in estate taxes.
NAMING MULTIPLE BENEFICIARIES OR SPLITTING YOUR IRA INTO SMALLER ONES
An IRA Beneficiary Designation Form will generally allow you to name multiple beneficiaries, or you can consider breaking the IRA into smaller accounts and having a separate beneficiary for each one. Under the old rules that allowed distributions based on a beneficiary’s life expectancy, this kind of planning made more sense; under the SECURE Act, this is no longer a particularly meaningful tool. However, if you wanted privacy regarding uneven distribution amounts, this could be a way to do achieve that.
WHAT ARE ESTATE TAXES AND WHY YOU SHOULD CARE
As mentioned previously, tax-deferred distributions are subject to income tax. In addition, when you die, your estate will have to pay estate taxes if its net value (including your tax-deferred accounts) is more than the amount exempt at that time. The “estate tax exemption” is $12.92 million in 2023 and the State of Maine has a $6.41 million exemption.
Although the majority of estates will not have an estate tax liability, some will, and there are planning strategies available to reduce or eliminate such taxes.
Estate taxes must be paid in cash, usually within nine months of death. If money must be withdrawn from a tax-deferred account to pay the estate taxes, the result can be disastrous — because income taxes must be paid on the money that is withdrawn to pay the estate taxes. You might actually pay (income) tax on money you pay in (estate) tax!
You can reduce your taxable estate by giving some assets to your loved ones before you die. You can buy life insurance within a special type of trust (so the insurance is not taxable in our estate) to pay estate taxes. And, if you are married, make sure you use both your estate tax annual exemptions of $17,000 per person. There are more in-depth articles on our website regarding these topics.
Everyone is entitled to an estate tax exemption but many married couples waste one exemption when they leave all their assets outright to each other. Currently, you can leave your spouse an unlimited amount of assets when you die and there will be no federal estate taxes at that time. But when your spouse dies later, he or she will only be entitled to one exemption. That could cause your family to pay too much in estate taxes.
Any assets you own (including a tax-deferred account) that you leave to anyone other than your spouse (your children, grandchildren, or a trust) can use your exemption. Splitting a large IRA into smaller ones will make this easier to do.
Let’s say, for example, that most of your money is in one large IRA and you do not have enough other assets to fully use your exemption. If you split the large IRA into smaller ones, you can name a trust as beneficiary of one of them. Then, if you name your spouse as beneficiary of this trust, the money from this IRA can provide for your spouse and use your exemption to save estate taxes.
CHANGING A BENEFICIARY
You can change your beneficiary at any time by filing the appropriate paperwork with the company. Your will does not govern who gets this asset, so make sure the beneficiary designation is current. Your minimum distribution requirements are not measured by who you name as beneficiary. We recommend keeping a copy of the Beneficiary Designation with your other estate planning documents so that your heirs know where to seek the assets when you are gone.
Some employer-sponsored plans (401(k), pension and profit sharing plans, etc.) have restrictions on beneficiary options. If your plan will not let you do what you want, consider rolling your money into an IRA as soon as you can. If your money is in an IRA and the institution will not agree to what you want to do, move your IRA to one that will.
Hopefully this complex issue will be less complicated from this reading. Before you make decisions in this area, it is wise to talk to an experienced financial advisor or estate planning attorney.
* This 10-year rule has an exception for a surviving spouse, a child who has not reached the age of majority, a disabled or chronically ill person or a person not more than ten years younger than the employee or IRA account owner.
Rev 11/23
The information presented on this website is general in nature and not intended to be legal advice. No attorney-client relationship will exist with Jones, Kuriloff & Sargent, LLC unless we agree in writing after a personal consultation. Please contact us for a consultation on your particular situation.
