Traditional IRAs and Estate Planning: A Few Golden Rules to Guide You in Naming Beneficiaries

By Loulena Miles

Miles & Torres Associates

Individual Retirement Accounts (IRAs) are an important part of most Americans’ life savings. In fact, about half of American families have an IRA account and among those, IRA plan assets were a clear majority of families’ total financial assets.

IRA’s popularity is mainly due to their built in tax advantages. Contributions to traditional IRAs lower your taxable income in the contribution year. That lowers your adjusted gross income, helping you qualify for other tax incentives you might not otherwise receive, such as the child tax credit or the student loan interest deduction.

Major tax advantages can also be available to an IRA’s inherited owners – if transferred carefully so as to comply with tax laws. A big tax advantage is commonly known as the “stretch” which allows a beneficiary to inherit an IRA asset and defer the distributions based on their own life expectancy. The assets continue to grow tax-deferred during the beneficiary’s lifetime – maximizing the amount that the beneficiary can invest. Note the “stretch” benefit is under Congressional scrutiny and may not always be available.

Nevertheless, confusion abounds on how best to transfer your IRA assets at your death, mainly because IRAs are governed by a complicated set of tax rules. If these rules are not followed, there can be fines and missed opportunities for future savings.  Therefore, the decision of how you transfer your IRA to your beneficiaries can be one of the most important estate planning decisions you can make. A good time to consider how you would want your IRA to transfer upon your death is when you set up your estate plan.

Many people choose to create a revocable living trust for the management of their assets when they are incapacitated and for when they pass away. However, deciding whether you name your trust as the beneficiary of your traditional IRA requires specialized knowledge and careful consideration. If a traditional IRA is transferred incorrectly it can potentially result in the loss of decades of tax deferred savings or unnecessary penalties for your beneficiaries.

Every IRA owner’s situation is different, necessitating specialized planning considerations, but there are a few general rules to know about IRAs that can kick start your thinking about who or what to name as your beneficiary. 

1.      Unless there is a compelling reason to name your trust as the beneficiary of your IRA, name individuals instead.

If you are married or intend for your IRA to pass to a chosen individual, or small group of chosen individuals, it is usually best to name your beneficiaries directly. The IRA will pass outside of probate and the transfer will be quick and relatively simple for your beneficiaries. Moreover, these beneficiaries can continue to hold the assets in inherited IRA accounts and reap tax deferred benefits for years, if not decades, depending on their life expectancy. Therefore, naming a trust as an IRA beneficiary is usually discouraged unless you have a strong reason to do so. Some reasons to name a trust as a beneficiary might include planning for the long-term care expenses of elderly IRA holders, protecting your assets from creditors after you die (IRAs have creditor protections for the original owner during their lifetime), reducing estate taxes (if you are one of the few who have more than five million in assets upon death), protecting beneficiaries with special needs who rely on public assistance for survival, and allowing for greater flexibility in managing the payouts for minors or young adults (and even then, you probably want to name the minor or young adult directly unless the IRA assets are quite substantial).  If any of these scenarios apply to you, it is best to talk to an estate planning attorney to evaluate your options.

2.      If you are married and want your spouse to inherit your entire IRA, it is usually best to name them outright as the beneficiary.

Spouses get preferential treatment when they inherit an IRA. Spouses have one option that nobody else has: rolling over inherited IRA assets into an IRA in their own name, and treating these assets as if they were their own. This may be a good choice if the surviving spouse doesn’t have an immediate need for the IRA assets and is looking to keep the money in a tax-advantaged account for as long as possible. Spouses also have the option of treating it as an inherited IRA and taking out the funds earlier than they otherwise would. The bottom line is that spouses have the most flexibility in how to manage the IRA assets if they are named directly as beneficiaries of the deceased spouse’s IRA. Also if you are married, you generally must name your spouse as the beneficiary of your IRA.  If you want someone else to inherit your IRA, you should get written consent from your spouse to name the other person. 

3.      If you name a minor as a beneficiary of your IRA, you might want to choose a guardian for management of the IRA assets.  If you don’t, one will be chosen for the beneficiary until he or she reaches the age of majority.

Unlike a spouse, minors (children under age 18) will not have the option of rolling IRA plan assets into IRA accounts in their own name. So children and all non-spouse beneficiaries generally have to begin taking minimum required distributions soon after they receive the inherited IRAs, based on their age. They will also have to pay the associated income taxes. Moreover, while they are under age 18, whoever is their guardian will have control over the management of the IRA assets.  One option is to name an adult individual of your choice to serve as a custodian for the IRA funds under the Uniform Transfer to Minors Act. This allows you to control who will manage the funds, instead of a parent, or whomever the court appoints as the child’s guardian. Another option is to name a trust as the beneficiary of the IRA and name the child as the beneficiary of the trust. If you are considering naming a turst, this should be done by an estate planning attorney because creating a trust for a minor requires some planning and forethought and there are potential drawbacks to naming a trust that should be considered.

4.      Know who your beneficiaries are and keep your beneficiary designations updated!

This is one golden rule that applies to absolutely everyone who owns an IRA account. You must check and double check your named beneficiaries every few years. Often when people do look, they are horrified to discover that their beneficiaries are not who they would currently want to inherit their assets. For example, it could be an ex-partner or a long-deceased family member, rather than their current partner or children. Whenever there is a major life change, it is time to consult and possibly update the beneficiary designations on these accounts. That means if you get married, divorced, have children, or more than 5 years have gone by since you last checked, it is time to look again.

5.      It is generally not a good idea to transfer title of your IRA account out of your name and into your trust during your lifetime.

The IRS has ruled that only an individual can own an IRA.  If you transfer an IRA to a trust, the IRS considers this a taxable distribution, just as though you cashed out your IRA. That means all of the money in the IRA is immediately taxable as ordinary income. Additionally, if you are not yet 59 1/2 years old, this is an early distribution and you have to pay an additional 10 percent penalty tax.  Moreover, your IRA funds are no longer in an IRA as far as the IRS is concerned, so the tax-deferred status of any future earnings is lost. If you want your IRA funds to be distributed through a trust, then you would name the trust as the beneficiary of your IRA. (This decision should only be made after consultation with an estate planning attorney, as described below).

6.      If you want to name your trust as a beneficiary of your IRA, see a lawyer or specialist.

Naming a trust as a beneficiary of an IRA is a complicated endeavor that should only be done with the utmost care. If you find that you have a compelling reason to do so, consider the following facts first. If your trust has multiple beneficiaries, the required minimum distributions generally must be based upon the life expectancy of the oldest beneficiary, leaving younger beneficiaries with less time for their assets to grow tax-deferred. Further, if you name an entity rather than a human being as a beneficiary in your trust (say a charity or nonprofit organization), no beneficiary of the trust will be able to qualify to stretch their distributions for tax deferred growth beyond the life expectancy of the original IRA participant. Finally, administering a long-term trust after the grantor passes away requires some expertise and time.   Only owners of IRAs with significant assets should consider naming a trust as a beneficiary.

If you’re still not sure who or what you should name as a beneficiary of your trust, call us for a free consultation.  Miles & Torres Associates 415-496-9396.