Andrew Cashman, JD, LLM Taxation May 12, 2017
There are many benefits of utilizing tax-advantaged retirement accounts. Most notably, they allow your contributions to grow on a tax-deferred (traditional) or tax-exempt (Roth) basis and the accounts provide significant asset protection from creditors. What’s more, the tax benefits can be significantly increased by naming proper beneficiaries for the accounts. This article will help you make an informative beneficiary-designation decision.
What Happens to My IRA, 401(k), etc. After I Die?
For many Americans, their retirement accounts are their biggest asset other than their home. Retirement accounts require account owners to name beneficiaries of the accounts which supersede your will and other estate planning documents. Unfortunately, the retirement account beneficiary designation decision is typically made very quickly when completing questionnaires required to open the account. Not only is the initial decision made hastily, but people often never revisit the designation as life changes. This lack of care can be a very costly mistake. (For related reading, see: Mistakes in Designating a Retirement Beneficiary.)
Naming Beneficiaries of Retirement Accounts
The options for naming a beneficiary of a retirement account generally fall into five categories:
- a spouse, if married
- children, grandchildren or non-family members
- your estate
- a trust
The option you choose will have significant consequences on your estate and your heirs. Below is a summary of the pros and cons of each option:
1. Spouse as Beneficiary
Many married people name their spouse as beneficiary to provide for the spouse after the owner’s death. Although this is very practical and oftentimes the best decision, you should consider naming other beneficiaries if your spouse has sufficient other resources to use after your death. A significant benefit to naming your spouse is that he or she is not required to begin taking required minimum distributions (RMDs) unless and until he or she reaches age 70.5. Another is that your spouse could name grandchildren or great-grandchildren as beneficiaries who may not be alive at your death, which will benefit them and could stretch the tax benefits for much longer than would have been possible at the time of your death. On the other hand, your spouse takes complete control of the account after your death—he can withdraw the money completely or name beneficiaries of his choosing. Either such decision may impede the tax, estate and other planning you completed prior to your death.
2. Someone Other Than Spouse as Beneficiary
Spouses have the option to combine an inherited IRA with their own IRA and can delay RMDs if they are not yet age 70.5 at the time of the owner’s death. Everyone else:
- must keep an inherited IRA separate from their own retirement accounts;
- cannot make additional contributions to the inherited IRA; and
- must begin RMDs in the year following the owner’s death or agree to withdraw the entire account within five years of the original owner’s death.
The most common reasons to name a child, grandchild or non-family member as beneficiary are because the account owner has no spouse, does not want to name that spouse as beneficiary for some reason, or for estate planning purposes. (For related reading, see: Designating a Minor as an IRA Beneficiary.)
Naming a non-spouse as beneficiary may increase tax benefits because the retirement account can continue to grow tax-free (Roth) or tax-deferred (traditional) for the life of the beneficiary. This is a powerful estate planning tool and could significantly increase the benefit to the child or grandchild as the RMDs will be based on their life expectancy. The downside is that the original owner has no control of the account after he dies. Not only can the beneficiary use the money immediately in whatever way she chooses, but the account may also be exposed to the beneficiary’s creditors.
3. Distribute Funds Directly to Charity
The tax on distributions from traditional (non-Roth) retirement accounts can be avoided by distributing the funds directly to charity. Therefore, persons wanting to give to charity at death should consider naming a charity as one of the beneficiaries of their retirement account. The charity’s portion of the account must be distributed prior to September 30 of the year following the owner’s death to reserve stretching options for other designated beneficiaries. (For related reading, see: Gifting Your Retirement Assets to Charity.)
4. Distribute Funds According to Estate Plan
People with detailed estate plans may want to name their estate as beneficiary so that the funds in the retirement account are distributed pursuant to the estate plan. Proceed with caution, however, as this may increase probate costs, remove the stretching options mentioned above and increase taxes. In this case the retirement account must be distributed in full within five years if the owner died before her RMD start date or over the plan owner’s remaining life expectancy if she died on or after her RMD start date. The estate must remain open while the funds are distributed. Because of this, only people with very complicated distribution schedules in their wills should consider naming their estate as beneficiary.
5. Protect Funds in a Trust
You cannot put a retirement account into a trust during your lifetime, but you can name a trust as beneficiary of the account. Trusts are a great option if you have concern as to how your beneficiaries will use the money after your death. If you name a trust as beneficiary, the IRS will treat the beneficiaries of the trust as the designated beneficiaries for purposes of determining RMDs if: (a) the trust is valid under state law; (b) the trust is irrevocable at or before the owner’s death; (c) the beneficiaries of the trust are identifiable from the trust document; and (d) the trustee meets the account custodian’s requirements. If these requirements are met, the life expectancy of the oldest trust beneficiary will be used to determine RMDs. If the requirements are not met, the account is considered to have no designated beneficiary and the estate rules above apply. The same asset protection and spendthrift clauses used in other trusts can be used in an IRA trust, making trusts the best option for many retirement account owners.
(For more from this author, see: The Pros and Cons of Your Retirement Account Options.)