One of the very important tenets of estate planning is to ensure that you’ve made an appropriate choice, or set of choices, for beneficiary(s) of your IRA account(s). The title of this article could be a bit misleading – the point of this article is to list some of the consequences of various choices for a beneficiary of your IRA.
Don’t get me wrong – this article doesn’t suggest that the tax consequences should drive your choice of beneficiary(s). Rather, the assumption here is that you have several beneficiaries to choose from, and other classes of assets that you can direct toward heirs that aren’t as able as others to take advantage of the tax-favorable provisions.
Following are the benefits and consequences of some of the major groupings of choices that you might make for beneficiary(s) of your IRA.
If you choose a young individual as the beneficiary of your IRA, your heir will be able to take advantage of long-term tax deferral using the method that provides for payout over the life expectancy of the beneficiary. By doing so, the tax-deferred status of the account can remain in force for a considerably long time (consider a 2-year-old heir, providing for 80+ years of potential tax deferral).
Older IndividualIf you choose an older individual as the beneficiary of your IRA, this heir can also take advantage of the life expectancy payout method – but the payout period will be much less (due to the age of the beneficiary). Therefore the tax-deferral benefit will be considerably less for the older individual versus the younger individual.
Spouse (any age)Directly
If you leave your IRA directly to your spouse by name, he or she can elect to treat the inherited IRA as his or her own IRA. This means that your spouse will be able to defer distributions from the account until he or she reaches age 70½, and then use the Uniform Life Table for distributions. As you know, the ULT is much more favorable than the Single Lifetime Table, which is the one required to be used by owners of inherited IRAs. Your spouse can also name his or her own beneficiary for any amounts remaining in the IRA at his or her death – which provides for additional deferral in the account.
If instead, you decide to leave your IRA to your spouse via a trust (even a look-through trust), you remove the possibility for your spouse to assume ownership of the trust (as described above). By doing so, the account must be treated as an inherited IRA, subject to the immediate Required Minimum Distributions from the account, regardless of the age of your spouse. Further deferral of taxes is limited in many cases, since if the spouse is younger than 70½ he or she has to take distributions now rather than delaying until age 70½. In addition, your spouse will be required to use the less-favorable Single Lifetime Table for the distributions; your spouse also cannot name his or her own beneficiary for the account for further deferral after his or her death.
Now, if the spouse is the sole beneficiary of the trust, the account can be treated as if it were directly inherited by your spouse, as in effect the look-through trust becomes a conduit trust. With a conduit trust, the effect is the same as naming your spouse the sole beneficiary of the account – so the same rules apply as when you leave the account directly to your spouse. The only difference is that you’ve spent extra money drafting the trust agreement.
Other Beneficiary OptionsGroup (versus Individual)
Leaving your IRA to a group of people instead of one person, this can introduce quite a bit of complexity to the situation. Where possible you could split your IRA into separate accounts and direct each account to an individual beneficiary, saving your beneficiaries a lot of extra headaches at your passing. If this is not possible or you would prefer not to split your account your heirs can do it later – it’s just a lot of extra paperwork for them that you could have handled for them in advance. See this article for additional information on splitting inherited IRAs.