By: Frank Armstrong, CFP, AIF
Pension plan and IRA beneficiary selection presents special opportunities and problems for account holders. Choosing the right beneficiary could allow generations of tax deferral on retirement assets, while a mistake could trigger a tax disaster.
Let’s step back and think about IRA planning in general. IRA’s are valuable wealth generators because they are usually funded entirely with pre-tax funds, and they grow in a tax-free environment until funds are distributed from the IRA to an owner or beneficiary. Even though taxes are eventually due, they are deferred, and funds that would have left the account to pay taxes are available to compound. Deferral results in additional wealth creation, so we generally want to do everything we can to preserve the benefit as long as possible. Proper planning gives us the opportunity to extend the tax deferral to additional generations, greatly enhancing the benefits for our heirs.
The future benefits that can be derived from an IRA may be a high multiple of the present “nominal” value. The IRA thus can be a goose that lays the golden egg. Give it careful attention, especially if your IRA is more than a trivial part of your net worth.
Fortunately, the new IRS Proposed Regulations covering Required Minimum Distributions (RMD’s) are much more favorable to taxpayers than previously, and greatly simplify planning.
- Deferral periods are longer during life, and offer more flexibility for estate planning.
- We are no longer locked into an irrevocable beneficiary designation at the Required Beginning Date (RBD) for mandatory distributions,
- Our beneficiary choice then will not affect our Required Minimum Distribution (RMD) calculations. Required distributions are calculated based on a joint life expectancy table assuming that the beneficiary is 10 years younger than the account owner. (There is one minor exception: where a spouse is more than 10 years junior to the account owner the real age of the spouse is used for the joint life calculation.)
- The beneficiary need not even be identified until after the death of the account owner.
Beneficiary selection is critical whether you’re 25 or 75. If the fickle finger of fate gets you before your time, the beneficiary selection will have a major impact on how your IRA assets are taxed. Naming the right beneficiary can give your heirs flexibility and generations of tax deferrals. Naming the wrong beneficiary can mess up the best of estate plans, and result in nightmare taxation.
If natural persons other than the spouse are named beneficiaries, the beneficiaries have two choices:
- They may distribute all the funds, and pay the taxes due on the IRA within five years of date of death.
- Far better treatment may be obtained by spreading the distributions and taxes over their remaining lifetimes. If they wish this treatment they must elect to do so before the end of the year following the death. If the beneficiary is a child or grandchild, for example, this option could give an additional 80 or more years of deferral on the funds. Younger beneficiaries will have negligible withdrawal requirements in the early years. So the value of the account should continue to increase until late in life when required withdrawals exceed growth in the account.
If you choose beneficiaries other than a spouse, make sure they know to make a timely election in order to obtain the additional deferral. They also need to understand that if they fail to take a required distribution, the penalty is a whopping 50% of the amount that should have been withdrawn.
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Selecting a beneficiary other than the spouse might be appropriate if there is no spouse, or if there are other adequate funds available to support the spouse. This arrangement should qualify for estate-tax exemption under the Uniform Estate and Gift Tax Credit.
Spouse as Beneficiary
Spouses are entitled to special treatment. If you name your spouse as beneficiary, he or she will either have the right to continue your IRA as a beneficiary, or to elect a spousal rollover. In either case, there is no estate tax due because of the unlimited marital deduction.
- If your spouse continues the IRA as a beneficiary, she may defer taking distributions until the owner’s Required Beginning Date. This arrangement might be beneficial for a spouse that was older than the owner and wished to prolong the deferral period.
- At the owner’s Required Beginning Date, or if death of the owner occurred after the Required Beginning Date, then the distribution period for the spouse would be determined by her remaining life expectancy calculated a year after death and reduced one year for each year thereafter.
- Or, if the spouse is under age 59 ½, distributions made from the inherited IRA will not be subject to the 10% penalty for premature distributions.
Spousal rollover arrangement:
- Alternatively, your spouse can roll your IRA into his or her own, and name a new beneficiary. The spouse can start a new deferral based on his or her own (if younger) age, and name new beneficiaries under the new IRA.
- A younger spouse might elect to split the IRA to get the benefits of both treatments according to her needs.
You may wish to name multiple beneficiaries for your IRA. As long as the IRAs are divided prior to December 31 of the year following death, each beneficiary can utilize their own life expectancy to determine required distributions. Otherwise, if the IRA is not split in a timely manner, the age of the oldest beneficiary will be used to compute the deferral for all beneficiaries.
Trust as Beneficiary
A properly drawn “qualified trust” may be named as a beneficiary. This trust might either operate as a marital trust, Q-Tip trust, or Uniform Credit Shelter Trust. The law “looks through” the trust to the beneficiaries to determine the appropriate deferral period. One big word of warning here: This must be done just right. The drafting requirements are very precise. Failure to comply with any one of the many technical requirements will probably mean that you will be deemed to not have a designated beneficiary.
Charity as Beneficiary
If you have charitable inclinations, you may designate your favorite qualified charity as beneficiary. This will result in a reduction of your taxable estate. Of course, the charity won’t have to pay income taxes on the proceeds.
A Word on Contingent Beneficiaries
Every IRA form has a place for a contingent beneficiary, and it’s not there just to take up space. In the event of a prior or simultaneous death of the primary beneficiary, it is imperative that a contingent beneficiary is named. If for any reason you should die without naming a valid beneficiary, your IRA will be subject to premature distribution and taxation. This is just about the worst possible outcome. Your family could be deprived of a generation or two of additional deferral on your account.
Failure To Name Beneficiary or Naming “Estate”
If you don’t name a beneficiary, or are otherwise deemed not to have a properly designated beneficiary, bad things happen. Naming your “estate” as contingent beneficiary isn’t sufficient. Estates are not “natural” persons. The total amount in your IRA must be distributed to your estate, and the taxes paid not later than the end of the fifth year following death. Congratulations, you have just killed the golden goose.