For many people, their IRA (or 401K) is their largest asset, other than perhaps their home, and making sure that is protected for their beneficiaries is important.  Here are some things to consider when naming beneficiaries.

• Name your spouse. As a general rule of thumb, if you are married you should name your spouse as the beneficiary of your qualified retirement accounts.  The tax laws include favorable provisions for treatment of IRAs which pass to a surviving spouse.   For example, a surviving spouse can rollover the IRA and make it her own which will allow her to take withdrawals over her life expectancy. Situations where it may not be appropriate to name your spouse include:
  • A second marriage where the IRA owner wants to make sure the balance of his IRA passes to his children at the death of the spouse
  • The spouse is not able to manage assets
  • The spouse is likely to need long-term care

• Consider the Stretch Out. The tax laws presently permit a designated beneficiary of an IRA to take withdrawals from the IRA over the life-expectancy of the beneficiary.  This is advantageous because the amount that does not need to be withdrawn grows tax-free.  Here’s an example.  Mom has a $600,000 IRA. She names her 60-year old son (Sam) and her 30-year old granddaughter (Gina) as the equal beneficiaries of the IRA.  According to the IRS, Sam has a life expectancy of 25.2 years and Gina has a life expectancy of 53.3 years.  Sam would be required to withdraw about 4% of his share ($11,900), the first year, while Gina could take out less than 2% (about $5,600).  Remember, the funds which do not need to be withdrawn continue to grow income tax free.

• Consider the Beneficiary. While the tax laws permit a beneficiary of an IRA to take withdrawals based on the beneficiary’s age, the beneficiary is not required to do so.  A beneficiary of an inherited IRA may withdraw as much as he wants, at any age, without penalty.  However, the withdrawals are 100% taxable income to the recipient which could result in a large tax liability and a significantly reduced balance.  For example, if the beneficiary of a $500,000 IRA takes all of the money out in one year, the income tax liability on that liquidation could be close to $200,000.   Further, the interest and dividends earned on the remaining balance of $300,000 will be reduced by income taxes every year.  If you have a large IRA that you plan to leave to beneficiaries whom you believe will ‘take the money and run’ you may want to re-consider your options.

• Never name a minor. Knowing that an IRA beneficiary can stretch out withdrawals based on life expectancy leads some people to name minor children or grandchildren as beneficiaries.  Don’t do it!!   When a minor is the beneficiary of an IRA the only way to gain access to the IRA is to have someone, usually a parent, petition the probate court to be appointed as the child’s conservator. This is an expensive and time consuming process.  But it gets worse! Once appointed, the conservator will be required to file annual accountings with the probate court reporting on the activity in the account. And even worse! In Massachusetts the courts require that the conservator (or her attorney) appear in court once per year to present the annual accounting to a judge for approval.  The costs involved could easily run many thousands of dollars.

• Consider naming a Trust as the beneficiary but be careful. Naming a Trust as the beneficiary of an IRA addresses many of the issues raised above. A Trust can:
  • Allow minor children to be the beneficiaries without the need for a conservatorship.
  • Ensure that the funds are withdrawn over the lifetime of the beneficiary rather than all at once.
  • Provide creditor protection for inherited IRAs.

The IRS has very strict rules for Trusts which receive qualified retirement funds.  If the Trust terms do not comply with those requirements it will not qualify as a designated beneficiary. The consequence is that the payout cannot be made over the life expectancy of the trust beneficiary and instead, all of the funds will have to be paid out of the IRA within five years of the IRA owner’s death and the tax paid.

Planning for the ultimate distribution of a large IRA is an important aspect of planning your estate.  This is money you worked all your life to accumulate.  Take the time to consult with a knowledgeable estate planning attorney who can help you understand your options and make the best choice for your family.

April 2017

© 2017 Samuel, Sayward & Baler LLC