Individual retirement accounts are some of the most sensible investment vehicles. They are tax deferred, protected from most creditors and can easily be transferred to a beneficiary outside of probate. In addition, they do not have a true maturity date: For traditional IRAs, you have to take required minimum distributions (RMDs), mandatory withdrawals of a certain percentage of the account every year, starting the year after you reach age 70½ and increase as you age.
The major sticking point is what happens to these accounts upon your death: How can your beneficiaries optimize tax deferral and continue creditor protection? Who you leave these accounts to and how you leave them can either make or break these objectives.
The following beneficiaries are the best options when it comes to passing on your IRA:
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Your Spouse
When you die your IRA typically turns into an inherited IRA. This creates different RMD treatment than when you take the distributions as the owner of the account. The main exception to the inherited IRA issue is transferring IRAs to your spouse.
Your spouse is the only individual who has the option of transferring your retirement plans to his or her name at the time of your demise. If the surviving spouse is younger than the deceased spouse (which happens to be the case more often than not), the receiving spouse now uses her longer life expectancy, and the commensurate smaller required withdrawal percentage, for RMD purposes. This allows for smaller distributions, which means less taxable income and more funds to continue growing tax deferred.
Younger Individuals
The concept of stretching RMDs is somewhat misrepresented to the public and is contingent on whether you live past April 1st of the year following the year you reached age 70½. This is the actual time you must start taking RMDs or face a penalty. If you die before this time, meaning no one has ever taken an RMD from your IRA, your beneficiaries can stretch RMD distributions based on their life expectancies.
This is a great benefit to younger individuals: Though they have to take RMDs even if they are younger than 70½ years old (inherited IRAs must begin distributing by December 31st of the year after your death, no matter how old the beneficiary is), the percentages to withdraw are quite small based on the beneficiaries' long life expectancies. If you die after the required begin date, RMDs are based on the longer of either your life expectancy or your beneficiary's life expectancy.
A See-Through Trust
Leaving funds to an entity that is not an actual human, such as an estate or charity, completely ruins RMD optimization: The beneficiary must withdraw all funds within five years. This can lead to an income tax burden that you would have wanted your beneficiaries to avoid.
A see-through trust can receive RMDs based on the beneficiary's stretching abilities noted above (thus it "sees through" to their life expectancy), yet protect the proceeds by holding the funds in trust. This is particularly useful when a minor is the beneficiary of a trust, since a minor cannot receive these distributions outright because they cannot individually own property.
A see-through provision is often just one component of a trust, meaning it is often just one part of a larger document.
The following beneficiaries are the worst options when it comes to passing on your IRA:
Your Estate
Naming "my estate" as beneficiary to your IRA is the absolute worst thing you can do: You potentially lose creditor protection of the IRA, ensure the five-year withdrawal rule for your beneficiaries, increase court and accounting costs and increase the time and complexity of your probate estate.
Both A Person and a Non-Person
All beneficiaries to a trust must have a life expectancy (i.e. be human beings) or else the five-year rule for distributions applies. This mistake is usually made when an IRA owner leaves a large amount of the plan to family members and a small amount to a charity, such as 90% to children and 10% to a church. Remember that all of the IRA funds must go to natural beneficiaries for stretch RMD purposes: Even leaving just 1% to a non-person invokes the five-year rule.
One way around this shortfall is to move some funds to a separate IRA, and leave that IRA solely to charity. This will benefit all parties: The charity receives all of the funds in its IRA tax-free, and your beneficiaries receive inherited IRAs with stretch RMD treatments available to them.
An Older Person
Leaving IRAs to an older individual is clearly bad for RMD purposes since the distributions are withdrawn at a higher rate. Of course, if you want to leave some funds to an older person and have no other assets to transfer, then RMD treatment might not really be a major concern for you. However, if there is a choice to transfer non-retirement assets instead, then those would be preferable.
A Spendthrift or Person With Creditor Issues
Spendthrift beneficiaries who receive IRA funds are disasters waiting to crash. Remember that every penny taken out of an IRA, inherited or otherwise, is taxable income. So a person in financial straits would not only deplete an inherited IRA quickly, but would also have to pay income taxes for every withdrawal. In addition, in 2014, the Supreme Court decided an inherited IRA is fair game for creditors during bankruptcy judgments.
Instead of making your spendthrift relative the outright beneficiary of your IRA, consider naming a see-through trust and have another family member act as its trustee.
As is often the case in estate planning, knowing the nature of the asset itself is usually not enough: You should know the future nature of the asset and the individual who shall be receiving it.
Daniel A. Timins is an estate planning and elder law attorney and a certified financial planner, helping clients with wills, probate, living needs and Medicaid planning.
-
6 Stunning Waterfront Homes for Sale Around the USFrom private peninsulas to lakes, bayous and beyond, Kiplinger's "Listed" series brings you another selection of dream homes for sale on the waterfront.
-
Six Reasons to Disinherit Someone and How to Do ItWhether you're navigating a second marriage, dealing with an estranged relative or leaving your assets to charity, there are reasons to disinherit someone. Here's how.
-
Should You Still Wait Until 70 to Claim Social Security?Delaying Social Security until age 70 will increase your benefits. But with shortages ahead, and talk of cuts, is there a case for claiming sooner?
-
Retirement Planning for Couples: How to Plan to Be So Happy TogetherPlanning for retirement as a couple is a team sport that takes open communication, thoughtful planning and a solid financial strategy.
-
Market Turmoil: What History Tells Us About Current VolatilityThis up-and-down uncertainty is nerve-racking, but a look back at previous downturns shows that the markets are resilient. Here's how to ride out the turmoil.
-
Could You Retire at 59½? Five ConsiderationsWhile some people think they should wait until they're 65 or older to retire, retiring at 59½ could be one of the best decisions for your quality of life.
-
Markets Roller Coaster: Resist the Urge to Make Big ChangesYou could do more harm than good if you react emotionally to volatility. Instead, consider tax-loss harvesting, Roth conversions and how to plan for next time.
-
Going Through Probate? How to Find the Right AttorneyJust having the skills and experience to do the job isn't enough. The probate attorney you hire needs to have the right temperament for your particular case.
-
Widow's Penalty: Three Ways to Protect Your FinancesHigher Medicare premiums, smaller Social Security payments, bigger tax bills … Financial changes can hit hard when a spouse dies. How to counter the blow.
-
Stick to the Plan: Don't Panic During Economic UncertaintyTake a breath and step back. Focus on a solid fiscal foundation to stabilize your investments during stock market volatility.
