Choosing an IRA beneficiary is as easy as using the beneficiary form provided by the IRA custodian, but the tax consequences often confuse people. The beneficiary designation form determines who inherits your IRA, not your will. Washington State passed the first “super-will” statute in the U.S. which allows wills to override beneficiary designation forms. I strongly recommend against using this provision. A will is admitted to probate, where a personal representative is appointed by the court. This can take weeks. The IRA custodian might act on a beneficiary designation form not know the will contains a provision to override it. The best course of action is to simply use the custodian’s forms and keep them updated.
It’s important for an investor to review designated beneficiaries annually at a minimum and after life-changing events including: marriage, divorce, remarriage, the birth or adoption of a child. Not naming a beneficiary leaves the beneficiary determination to the terms of the IRA custodial agreement, which could lead to naming the estate or creating a succession order such as spouse, children, grandchildren, etc. Here are some basic guidelines on naming an IRA beneficiary.
Choosing an IRA Beneficiary: Spouse
A spouse beneficiary generally has the following options upon inheriting an IRA:
- Rollover the deceased spouse’s account into his or her own IRA or a qualified plan. This transaction is tax-free and is permitted whether the account owner died before or after the commencement of taking required minimum distributions (RMD) at age 70½. If the spouse is younger than age 59½, the 10% premature distribution penalty reattaches when the inherited IRA becomes his or her own.
- Elect to remain a beneficiary and not do a spousal rollover. RMDs do not begin until the later of December 31 of the year the IRA owner would have turned 70½ or December 31 of the year following the year of the account owner’s death. This is generally suitable if the inheriting spouse is under age 59½, so the 10% penalty does not reattach to any distributions since the surviving spouse may make withdrawals as desired without penalty.
- If the spouse is not the sole beneficiary, the spouse is treated as a non-spouse beneficiary subject to the rules below. A beneficiary can disclaim his or her right to the inherited IRA and effectively make the surviving spouse the sole beneficiary.
Choosing an IRA Beneficiary: Non-spouse
Once a non-spouse inherits an IRA, a non-spouse can stretch the distributions based on his or her own life expectancy. The beneficiary is required to take RMDs annually commencing the year after the account owner’s death. Life expectancy (“stretch”) is based on the beneficiary’s age in the year after the account owner’s death.
Should the beneficiary fail to take the minimum distribution by December 31 in the year after the account owner’s death, the stretch option is most likely lost. Instead, the account must be distributed to the beneficiary by the last day of the calendar year, which includes the fifth anniversary of the account owner’s death (5-year rule).
Choosing an IRA Beneficiary: Non-person
An account owner also has an option to name a non-person, such as a charity or estate, as his or her beneficiary. Only persons who are named on the beneficiary form can stretch IRA distributions over their life expectancy. Consequently, when a non-person is the sole or co-beneficiary, the ability to stretch withdrawals over the human beneficiary’s lifetime(s) can be lost if the account is not properly segregated into its component parts for each beneficiary (or paid out) by September 30 of the year following the account owner’s death.
An extra step for SDIRAs.
The IRA designation form is part of the initial paperwork for your account setup with the IRA custodian. This is a form you create directly with them, not through our office.
Self-directed IRA clients need to remember that their beneficiary inherits the IRA, not the assets inside the IRA (an LLC, real estate, etc). The custodian may appoint the beneficiary to become the new LLC manager if your beneficiary wants to continue the current investments, but this is not automatic. Your beneficiary needs to know prohibited transactions, reporting requirements and how to take RMDs, if necessary.