IRA Beneficiary: You Have Options


An IRA is often the largest asset involved in estate planning. Unfortunately, when it comes to naming a beneficiary for your IRA, many people believe that their best choice is to name their spouse. This may be the correct choice. However, given the uncertainties of the future, proper estate planning should afford options depending on the circumstances at the actual time of death. For example, what happens in the event both spouses die in a common disaster? The children could then draw out all of the IRA money without any restrictions. What if the second spouse to die in a common disaster has children from a prior marriage? Would those children inherit the IRA funded by their stepparent? Fortunately, you do have options.

One of the benefits of naming your spouse as beneficiary of your IRA is that your spouse can “rollover” your inherited IRA into their IRA. Thus, the inherited amounts become subject to the tax and withdrawal rules applied to the IRA of the inheriting spouse. Required minimum distributions begin at age 70½and penalties will apply with respect to distributions taken before age 59½.

A surviving spouse named as an IRA beneficiary does not have to rollover an inherited IRA. A spouse can treat the inherited IRA as their own account. The inheriting spouse simply designates himself as the IRA owner with the financial institution that is custodian of the account. This is the default option under the tax rules. A spouse will automatically be treated as the new owner of the IRA if he makes any contributions to the IRA, does not rollover the IRA or fails to take required distributions as a beneficiary. As the IRA owner, the age of the surviving spouse determines required minimum distributions.

Often overlooked in naming a spouse as the IRA beneficiary is the fact that once the surviving spouse inherits the IRA, the IRA owner has lost control to address future contingencies such as estate tax planning, lawsuits, Medicaid Spend Down, reckless spending of children, loss of tax deferral and unnecessary income tax. Full control of the IRA has been given to the surviving spouse to give away or lose the IRA due to detrimental influence or poor judgment.

If your spouse can live comfortably after you die without your IRA assets or if you are widowed or not married, you may want to name your children, grandchildren or other individuals as beneficiaries of your IRA. The IRS now allows a non-spouse IRA beneficiary to “stretch-out” required minimum distributions (“RMDs”) over a much longer period, allowing a non-spouse beneficiary (for example, a child) to take or “stretch-out” the taxable RMDs using his or her own life expectancy rather than the shorter life expectancy of the original IRA owner (the parent). This means that money inside an inherited IRA may now compound much longer, on a tax-deferred basis.  Many IRA owners and their professional advisors incorrectly “assume” that the IRA beneficiaries will make the right “stretch-out” decisions, or at least seek an advisor’s help before they take withdrawals. Unfortunately, an IRA beneficiary is not prohibited from withdrawing more than the RMDs and may instead decide to cash out the IRA earlier than required, forfeiting the stretch-out. By naming your child or grandchild as beneficiary there is nothing that will prohibit them from going to your IRA custodian, requesting a check for the total amount of your IRA and then immediately cashing the check. This results in your IRA being subject to a new set of potential adverse situations (for example, in-laws, the child’s divorcing spouse, creditors, poor spending habits, etc.).

Naming a trust as beneficiary of your IRA will give you the maximum control over your tax-deferred money after you die. That’s because the distributions will be paid according to your written instructions, dictating who will receive this money and when, keeping your retirement money safe from irresponsible spending and creditors. In a recent Wall Street Journal article, retirement columnist Kelly Greene observed, “Many parents want to control how quickly their children can draw down the retirement accounts they inherit – and are fixating on trusts as the answer.”

There are two types of trusts that can be utilized as an IRA beneficiary: the Conduit Trust and the Accumulation Trust. With an Accumulation Trust, the trustee is not required to immediately distribute funds from the IRA and they can be held in the trust. The advantages of accumulating the distributions instead of paying them directly are: asset protection, spendthrift issues, incentive distributions and further tax planning.

In order to ensure long term tax deferral, a “conduit” trust (rather than an accumulation trust) may be desirable in certain cases. Since a conduit trust has a single individual as the primary beneficiary, the trustee is required to take at least the RMD amount from an inherited IRA each year and pass that amount directly through to the trust beneficiary. With a conduit trust, the primary trust beneficiary’s life expectancy, not the original owner’s life expectancy, can be used to stretch RMDs over this younger life.  By naming a trust as the beneficiary, an IRA owner can control the ultimate disposition of the principal, while still obtaining the marital deduction for the IRA benefits.

The disadvantage to the conduit trust is that distributions can’t be accumulated in the trust. They must be passed through to the trust beneficiary, who may spend the money or lose it to creditors. However, the IRA principal would still be protected.

Robert S. Keebler, a nationally known CPA specializing in IRA planning often advises clients to set up a conduit trust with a “toggle switch.” By including special “toggle switch” language when the trust is set up, the trustee can have a one-time option to switch to a more protective accumulation trust, as described above, between the IRA owner’s death and September 30th of the following year.

The federal rules governing trusts as beneficiaries of retirement accounts are difficult and uncertain. Some company retirement plans do not allow life expectancy distributions. No one should make a decision concerning the naming of a retirement plan beneficiary without first consulting with a knowledge professional experienced in IRA planning. Be sure that you make an informed decision.

Greg Walker is an attorney located at the Estate Planning Center, Alexandria, Louisiana. To discuss trust and other estate planning needs contact an attorney with the Estate Planning Law Center at (318) 445-4516 to schedule a free no obligation consultation.