Choosing the right beneficiary(ies) of your IRA is one of the most important and crucial decisions you can make in estate planning. Choose wisely and you can ensure your legacy is passed on and your heirs receive huge benefits: tax-deferred growth and asset protection. Choose poorly (or not choose at all) and your assets could go to the wrong people, get paid out too quickly and/or could get hit with high income taxes. The right choice for one client is not necessarily the right choice for another. Sundvick Legacy Center is here to answer your questions and present your options.
Doesn't My Will Designate Who Gets My Money?
A Will cannot designate how your IRA (or other retirement accounts) gets paid out unless your estate is the beneficiary, which has major tax implications and loss of asset protection opportunities. A beneficiary designation attached to your retirement accounts supersedes anything you have in your Will or Trust. This is why it is so important to ensure your beneficiary designations are correct.
What Are My Beneficiary Options?
You have several options: Your spouse, your children/grandchildren or others, a charity, a trust or a combination of these.
Naming your spouse might sound like your best option, and it might be in your case, but it is not without its drawbacks. Your spouse is the only person who can treat your IRA like their own after you die. This is called a "spousal rollover" and can ensure your spouse is provided for after your death and can further delay income taxes until your spouse must start taking his/her required minimum distributions. In addition, if your spouse is more than 10 years younger than you, your required minimum distributions will be less by using a different life expectancy chart, which can improve your money's tax-deferred growth. If your spouse dies before you, you can name a new beneficiary and the distributions will then be based on their life expectancy.
The pros and cons of naming your spouse as beneficiary are the same: your spouse has complete control over the money, which in many situations is fine. But, consider what happens if your spouse remarries or is the type to be easily influenced by others. They have no obligation to pass your IRA assets on to the people you'd like to receive them, such as children from a previous marriage, and can instead choose to pass it on to his or her new spouse or others. Another drawback is that if your spouse becomes incapacitated the court could take control over the money and your spouse's creditors might end up with your IRA assets. This is why it is so important to pre-plan for disability as well as passing away.
Your Children/Grandchildren or Others
There are many reasons why you might choose your children, grandchildren or other individuals as your beneficiary(ies), such as knowing your spouse will otherwise be well-provided for after your death, have good reason to believe your spouse will pass away before you or you're not married. The benefit to naming these people as beneficiaries is that it will allow you to stretch out your assets; the younger the beneficiary is, the longer your IRA will grow tax-deferred. As an example, if you leave your 20-year-old grandchild an IRA worth $100,000, over the course of the next 63 years (the calculated life expectancy), your money can provide your grandchild with over $1.7 million in income. That's assuming a 7% annual return with your grandchild withdrawing only the required minimum distributions. The income is subject to income taxes, but wouldn't you rather your beneficiary benefit from $1.7 million than $100,000? Ensuring your assets grow for as long as possible can be the difference between leaving behind a modest legacy and one that can span generations.
The con to naming an individual as a beneficiary is the same as leaving the money to your spouse: they have complete control over the money. You might intend for your beneficiary to stretch out the money per the above example and potentially leave your legacy for others to benefit from as well. However, your IRA assets are at risk of being cashed out or may be at the mercy of your beneficiary's creditors, spouses, ex-spouses and the court.
If part of your Legacy Plan includes donating to a charity, leaving the charity as a beneficiary to your IRA could be beneficial, not just to the charity, but to your loved ones. The charity will pay no income taxes on the money it receives and what you donate will not be included in the rest of your taxable estate, so that means your loved ones will have to pay less in estate taxes. It is important to note that if you choose to leave money to a charity as well as other beneficiaries within the same IRA, the calculated life expectancy for distributions will come from the charity; with a life expectancy of zero, this could force the IRA to be paid out at an incredibly-accelerated schedule, taking away any chance for tax-deferred growth. If you are interested in leaving money to charity as well as other beneficiaries, make sure the IRA is split into separate IRA accounts by the end of the year following the year of the original owner's death. This way, the individual beneficiary can stretch out his or her respective inherited IRA based on his or her own age.
The Treasury Regulations do allow an IRA Inheritance Trust, aka an "IRA Legacy Trust," under specific construction requirements, to be a designated beneficiary eligible for stretch-out treatment as an Inherited IRA after the IRA holder passes away. Furthermore, if properly structured and implemented, multiple individual beneficiaries can utilize their respective ages when their IRA portion is stretched out to his or her own sub-trust within the main IRA Inheritance Trust. Overall, what must be weighed in drafting such a trust are the financial and estate planning goals of the IRA holder, including the income and estate tax consequences and asset protection considerations. Not just any trust should be named as a beneficiary of an IRA and extreme caution should be used to retain an attorney with advanced knowledge of this strategy or there is significant risk in accelerating the income taxes due on your IRA after you pass.
However, if you are concerned about protecting your beneficiary's inheritance from irresponsible spending, from divorces, creditors or from being accidentally disinherited, this strategy is definitely worth looking into.
A Combination of Beneficiaries
You are not limited to the options above; you can choose to utilize a combination of options to optimize and protect your legacy. Working with an experienced Estate Planning attorney with a thorough Estate Planning process will help guide you towards which of these options creates the best balance for your desired results.
What Are Estate Taxes?
Estate taxes are in addition to income taxes and must be paid after you die. They are to be paid in cash and, if the money needs to be withdrawn from a tax-deferred account, it's not only subject to estate taxes but also income taxes. Under current law, the 2019 federal exemption is $11.4 million. Any amount over this is taxed at 40%. This means you can leave up to $11.4 million to heirs and pay no federal estate tax (this amount may change after 2025). Some ways to reduce estate taxes are to give gifts to loved ones while you are still alive, set up an Irrevocable Life Insurance Trust or transfer part of your wealth to a charity through a Trust. Your trusted advisors can work with you to figure out the best way to help your loved ones avoid excessive taxation.
The bottom line is, you need to get professional advice and have a properly-structured Estate Plan if you want to optimize your intended legacy. Sundvick Legacy Center's mission is to educate our clients and help navigate them through these important decisions to secure their future legacies for generations to come. If you do not have an Estate Plan, or want your Estate Plan reviewed, contact us today to schedule an appointment.