Designating IRA Beneficiary Critical in Estate Planning
Properly designating your IRA beneficiary can be an important part of your estate plan. Otherwise, your heirs may have to pay more income and estate tax than necessary after you are gone.
You must customize your IRA beneficiary designation to fit your goals. The most common beneficiary designations are spouses, children, grandchildren or other loved ones. You also may name a trust, a charity, or a combination of individuals, trusts or charities. After your death, distributions from your IRA will be required, and who you’ve named as beneficiary can dramatically affect the income tax consequences. Let’s examine important considerations when completing your IRA beneficiary form.
It is Important to Name a Contingent Beneficiary
If you name an individual as the primary IRA beneficiary, you also should name a contingent beneficiary. Why? Because your primary beneficiary may predecease you. If your IRA does not have a designated beneficiary, most plans require your estate to be the default beneficiary. This usually produces unfavorable tax results.
IRA benefits payable to an estate must be distributed within five years of your death if you die before your required beginning date (RBD — April 1 following the calendar year in which you reach age 70 1/2) or during your remaining single-life expectancy if you die after your RBD. An individual, and certain trusts can enjoy more favorable tax treatment, however, because they generally are permitted to take required minimum distributions (RMDs) from an inherited IRA over the life expectancy of the individual or of the trust beneficiary.
In addition, in 2013, an estate reaches its highest income tax bracket (40%) once taxable income exceeds, $11,950, while an individual must have more than $400,000 ($225,000 if married filing separately) of taxable income before the 40% rate applies.
How to Name Multiple Individual Beneficiaries
If you name multiple individuals — such as your children — as your primary beneficiaries, they must use the oldest beneficiary’s life expectancy to determine the RMD from your IRA. This is often called the “oldest heartbeat rule.” An exception to this rule provides that, if the IRA is divided into a separate account for each beneficiary, each beneficiary may use his or her own life expectancy to measure the RMD. To do this, each separate account must be established by September 30, of the year following the year of your death.
You should also specify what happens to the share of a child who predeceases you. State law generally presumes that a bequest to a blood relative automatically passes to that relative’s descendants in such situations. That presumption, however, may not apply to an IRA beneficiary designation form. In fact, many IRA custodian agreements require that, in the case of multiple primary beneficiaries, the account be paid equally to those class members who survive you, unless you specify otherwise.
If you name your children equally as primary beneficiaries, you probably want a deceased child’s share to pass to his or her children (your grandchildren). This distribution method often includes the phrase “by right of representation” or the Latin phrase “per stirpes.” Thus, you may specify on your IRA beneficiary designation form, for example, “My children, Alan, Brian and Catherine, who survive me, in equal shares, except that a deceased child’s then-living children shall take in equal shares by right of representation the share that the deceased child would have received if living.” Or you could specify, “Equally to my children, Alan, Brian and Catherine, or a deceased child’s surviving issue, per stirpes.” Either designation will create the desired result.
How to Name your Living Trust as Beneficiary
An IRA participant with a living trust may consider naming it as the primary or contingent beneficiary. (If married, the participant may, for example, name his or her spouse as primary beneficiary and the living trust as the contingent beneficiary.)
When you name a living trust as either a primary or contingent designated beneficiary, ensure the trust agreement is drawn properly. If it isn’t, the entire account balance may have to be withdrawn within five years of your death. Additionally, if the trust provisions governing how trust assets are to be divided upon your death are not properly drawn, the designation of the living trust as a beneficiary of the IRA may accelerate the income tax on the IRA as income in respect of a decedent.
Frequently, a participant’s living trust divides into shares when the grantor dies. For example, say you have a living trust and the trust agreement provides that on your death the trust assets are allocated and divided equally among your three children. Is the separate account rule available to your three children as beneficiaries of the living trust? Must the RMD be paid over the life expectancy of the oldest child? Or, may each child use his or her own life expectancy?
The IRA minimum distribution rules say that the separate account rule does not apply. For the separate account rule to apply, the allocation and division of the IRA into separate shares for each of the three designated beneficiaries must occur in the IRA beneficiary designation form, rather than in the living trust agreement.
Therefore, if you want shares passing to your children to qualify as separate accounts, you must name them (or create separate trusts for them) directly as IRA beneficiaries, instead of naming your living trust as beneficiary.
Carefully Considering your Beneficiary Designation Helps Manage Tax Bite
When you designate your IRA beneficiary, pay careful attention to the tax and non-tax consequences. Because the rules are complicated and potential tax traps exist, please seek the advice of tax, legal, and accounting professionals before making any IRA beneficiary designation.
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