Designating a Beneficiary for Your IRA is More Important Than You Might Think

When planning for the distribution of your estate, creating a Will might not be enough to ensure that your estate is divided as you would have wished and that your legacy is kept as intact as possible. If you have an IRA, you must give careful consideration to its beneficiaries in order to avoid excessive taxation and probate fees.

If, at the time of your death, a beneficiary of your IRA is not explicitly named, the funds in your IRA go directly to your estate and are then distributed according to your Will (or by state law if no Will is present). You do not want this to happen for several reasons. First, if your IRA goes to your estate, it becomes subject to probate, which means that the funds in your IRA are subject to fees levied by any legal professional involved in the administration of your estate. Second, as part of your estate, the IRA is also fair game for creditors. Taken together, the time and costs associated with probate and creditors' claims can significantly diminish the value of your IRA. By naming an individual as the beneficiary of your IRA, you can avoid these unnecessary costs and keep the value of your IRA intact.

A third problem that will arise if you do not name a beneficiary and your IRA goes to your estate is that you will lose the benefits of a "stretch IRA." A stretch IRA enables your beneficiaries to stretch the funds in your IRA over a longer time period so that the benefits received last longer and are more valuable. For example, consider the following scenarios.

IRA Distributions As Part of Your Estate

If the IRA goes to your estate upon your death because you did not name a beneficiary, and if you die before beginning your required minimum distributions (which begin at age 70.5), the beneficiaries of your estate are required by law to withdraw the sum total of your IRA by the end of the fifth year following the year of your death. If you die after beginning your required minimum distributions, i.e., if you die after age 70.5, then your beneficiaries are required by law to make withdrawals priced according to your life expectancy, and such withdrawals must be begun by the end of the year following the year of your death. In addition, if you happen to not make your required minimum distribution for the year in which you die, your beneficiaries are responsible for making this required minimum distribution on your behalf in as short a period following your death as possible; if they fail to do so, your beneficiaries will be looking at a 50 percent penalty as well as an income tax bill for the amount of the failed withdrawal.

IRA Distributions When Assigned To a Beneficiary

If you have assigned a beneficiary to your IRA, you can expect a much better picture to emerge than that illustrated above. Your beneficiary will be legally permitted to stretch his or her IRA distributions over a much longer time period.

If your beneficiary is your spouse, he or she can roll over your IRA into his or her own IRA and begin taking minimum required distributions at age 70.5. This way, your spouse can avoid required distributions upon your death. Another alternative for your spouse is to leave the funds in your IRA and withdraw minimum required distributions based upon his or her own life expectancy from the end of the year following the year of your death or the end of the year in which you would have turned 70.5.

If your beneficiary is not your spouse, he or she will make minimum required distributions based upon his or her life expectancy. As you can imagine, naming a younger beneficiary, such as a child or grandchild, can really pay off. This is because a younger age assumes many years left to live, and required minimum distributions can be as low as 1 or 2 percent for the initial year. This percentage will gradually increase as the beneficiary ages, but low distributions leave more money in the IRA for growth and do not impact income taxes as heavily as would withdrawing the entire sum within a five-year period.

For a case in which you have already begun your required minimum distributions and your nonspousal beneficiary is older than you, he or she is permitted to use your life expectancy to calculate the required minimum distributions.

As you can see, naming a beneficiary for your IRA is important and should not be overlooked.