Planning Strategies for IRA Beneficiary Designations

By Robin M. Stoner, CPA/MST

Individual retirement accounts (IRAs) are often the most significant asset an individual possesses. IRAs also represent a significant source of future revenue for the federal government. IRAs can be subject to both income tax and estate tax. In addition, an excise tax penalty may apply if distributions are taken too early, too late or in insufficient amounts. The benefit of an IRA is that earnings grow tax-free. Because of the power of compounding, significant wealth accumulation can be achieved the longer the IRA remains untouched.

As distributions are taken by the owner, the withdrawals are subject to income tax. Upon the IRA owner’s death, the IRA will be included in the owner’s estate. If the owner has a taxable estate, the IRA will then be subject to estate tax. The owner of an IRA is required to start distributions not later than April 1 of the year after he or she turns age 70½. This is called the required beginning date (RBD). The owner may take the distributions over his or her life expectancy or the joint-and-survivor life expectancy of the owner and a designated beneficiary. A younger designated beneficiary will allow the distributions to be taken over a longer period of time, thus deferring income taxes. Careful selection of a designated beneficiary yields significantly different results during the owner’s lifetime as well as after the owner’s death. Several alternatives are discussed below.

Spouse

Naming one’s spouse as an IRA beneficiary has decided tax advantages and is usually the preferred course of action for married taxpayers unless special circumstances dictate otherwise. The value of the IRA can be sheltered from estate tax by the marital deduction. The spouse-beneficiary has more leeway when the IRA owner dies. The spouse-beneficiary may treat the IRA as their own, naming a new beneficiary (possibly younger) and postponing required distributions (or further distributions) until the spouse-beneficiary is 70 1/2 years of age. Alternatively, the spouse-beneficiary can step into the shoes of the owner allowing for distributions to be delayed until the owner would have reached 70 1/2 or penalty-free premature distributions on account of death.

Estate

The owner of an IRA may name his or her estate as the beneficiary. If no beneficiary is named, the estate will be the deemed beneficiary unless the IRA agreement provides for a default beneficiary. If the estate is the beneficiary, the account balance must be withdrawn at any time or times prior to December 31 of the fifth year after the year of the owner’s death (five-year rule). If the IRA owner was recalculating his or her life expectancy each year to determine minimum distribution requirements, life expectancy drops to zero in the year following the year of death and the entire account must be distributed by December 31 of the year following the year of death. The estate as beneficiary must withdraw the IRA under these rules and will be subject to income tax on the distributions. However, the estate need not distribute the payments to the estate beneficiaries.

Non-spouse

A non-spouse beneficiary may be one’s children, grandchildren, other individuals or a qualified trust. If distributions have not begun, the IRA should allow a chance of five-year or lifetime payout. If the beneficiary is younger than the IRA owner, distributions can be made over the life expectancy of the designated beneficiary starting December 31 of the year after the owner’s death. For a younger beneficiary, this will have a significant impact on increasing the deferral period. If the owner is receiving minimum distributions at the time of death, the general rule is that the remaining balance must be distributed at least as rapidly as under the method used before death.

Charity

Naming a charity as the beneficiary of the IRA could be an ideal solution under certain circumstances. The charity will not pay any income tax on the distributions and the estate will receive the benefit of a charitable deduction. The charity is not considered to be a designated beneficiary so distributions at date of death will follow the five-year rule. One disadvantage to using a charity as the beneficiary is that if the owner’s required beginning date begins before his death, distributions must be based upon the owner’s life expectancy as opposed to using a joint-and-survivor life expectancy. Because a charity cannot be a designated beneficiary, distributions during the owner’s life can only be based on the owner’s life expectancy. This could significantly reduce the deferral of distributions and benefit no charity if the owner lives beyond their life expectancy.

Multiple beneficiaries

The IRA owner may want to select multiple beneficiaries. Where this is done, the age of the oldest beneficiary is used for the joint-and-survivor life expectancy. Establishment of separate IRA accounts for each beneficiary would allow the ages of the younger beneficiaries to be used. This must be done before the RBD.

Other considerations

Read the IRA agreement. Not all IRAs offer the same options. If the owner fails to designate a beneficiary, some IRA agreements may provide a default provision. For example, the agreement may designate a default beneficiary as the owner’s spouse, children or parents.

Some beneficiary forms may not allow the IRA owner the flexibility he or she desires. A separate form or instructions may need to be substituted or attached to the original forms. Finally, the IRA agreement may not provide guidance for correction of errors. As a result, there may be no consistency among IRA providers in resolving problems.

Robin M. Stoner, CPA/MST is a Tax Manager for Echelbarger, Himebaugh, Tamm & Co., P.C. (EHTC). Robin specializes in IRS representation for individuals and businesses.  Robin Stoner may be contacted at 616.575.3482 or robins@ehtc.com