Compliance Article
04/27/2007
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Planning for the future—isn't that what an individual retirement account (IRA) is all about? Planning for future IRA distributions, by both IRA owners and beneficiaries, can help avoid costly tax mistakes and increase overall retirement plan value. This article will discuss three common mistakes that IRA owners and/or their beneficiaries make and how to easily avoid them. Understanding these issues will help you explain the potential consequences—while not providing tax advice—to IRA owners and their beneficiaries as they inquire about and plan for IRA distributions.
Mistake #1: Not Naming an IRA Beneficiary
An IRA owner is not required to name a beneficiary. Similarly, an IRA owner is not required to update beneficiary designations when life events—such as death of a beneficiary, divorce, or birth of a child—occur. However, failure to do so directly affects who will receive the IRA assets and the long-term value of the IRA payout after the owner's death. In addition, not naming a beneficiary could result in an accelerated payment schedule upon an IRA owner's death, potentially increasing the tax burden on the distribution recipients.
When an IRA does not have a named beneficiary, the IRA will typically have to pass through to the decedent's estate. The estate may have to go through probate, which can be expensive. Probate also increases the time a decedent's heirs will have to wait before having access to the IRA assets. An estate will also not be able to take full advantage of distributions over a life expectancy. Depending on the timing of the IRA owner's death, an estate as IRA beneficiary will have to take distributions either over a five-year period or over the decedent's remaining single life expectancy, which is generally shorter than an individual beneficiary's life expectancy.
Example
John, age 84, died in 2005. He chose not to name an IRA beneficiary. In 2006 the personal representative of his estate elected single life expectancy distributions over John's remaining life expectancy of 7.1 years. However, if John had named his nephew Taylor, age 24 in 2006, as his primary beneficiary, Taylor could have taken distributions over his own life expectancy of 59.1 years. Even though John's estate is allowed to take distributions over a number of years, it is common for an estate to close an IRA within a year of death, further increasing the short-term tax burden.
Finally, and this may be the worst consequence of not naming an IRA beneficiary, the IRA proceeds may go to someone that the IRA owner had not intended.
Mistake #2: Naming a Trust Rather Than a Spouse as Primary Beneficiary
Many IRA owners have trusts, most commonly "living" or "grantor" trusts. A trust can be an IRA beneficiary, but that may not result in the desired distribution options. The death distribution rules for trust beneficiaries are much more restrictive than those for spouse beneficiaries. A spouse beneficiary can move the IRA assets into his/her own personal IRA—thereby reducing or delaying required distributions. In addition, a spouse would then be able to name his/her own beneficiaries—including naming a trust. A spouse beneficiary can also elect to take death distributions from the decedent's IRA based on the spouse's own single life expectancy—an option that may not be available to a trust beneficiary. Naming a spouse rather than a trust as primary beneficiary provides greater flexibility with regard to distribution of the IRA assets. IRA owners should consult with a tax professional or financial planner to determine if naming a trust as beneficiary of the IRA is the right thing to do.
Mistake #3: No Rollover Available
A nonspouse beneficiary who takes a lump sum distribution from an inherited IRA cannot roll over any portion of the distribution to any type of IRA, including the one from which the distribution came. This distribution triggers taxation of the entire inherited IRA. The ability to take distributions over a single life expectancy and the potential for growth over the distribution years is lost. This is key for Roth IRAs, as growth would likely be tax free. For traditional IRAs, taxes owed for the year of distribution will increase. Note: A spouse who inadvertently takes a lump sum distribution can roll over a death distribution to his/her own personal IRA within the 60 calendar days.
Conclusion
IRA custodians/trustees need to understand the distribution options so they can adequately explain them to IRA owners and beneficiaries. Providing accurate information to an owner or beneficiary is not giving tax advice; it is simply providing information so that the owner or beneficiary can make an informed decision. It is the owner's or beneficiary's responsibility to seek professional tax advice and choose the option that best fits his/her financial plan. Ignorance can be awfully expensive.
