Keeping Your Designated IRA Beneficiary Current is Important

Article Highlights:

  • How Naming Beneficiaries Impacts Traditional IRA Distributions
  • The Impact of Naming Your Trust as a Beneficiary
  • IRA Beneficiary Taxation

Keeping your designated IRA beneficiary current is very important. You may not want your account going to your ex-spouse, and you certainly do not want a deceased individual to be your beneficiary. In addition, the decision concerning whom you wish to designate as the beneficiary of your traditional IRA affects:

  • The minimum amounts you must withdraw from the IRA when you reach age 72;
  • Who will get what remains in the account after your death; and
  • How that IRA balance can be paid out to beneficiaries.

What’s more, a periodic review of your named IRA beneficiaries is vital to ensure that your overall estate planning objectives will be achieved in light of changes in the performance of your IRAs and your personal, financial, and family situations. For example, if your spouse was named your beneficiary when you first opened the account several years ago and you’ve subsequently divorced, your ex-spouse will remain the beneficiary of your IRA unless you notify your IRA custodian to change the beneficiary designation.

The issue of naming a trust as the beneficiary of an IRA comes up regularly. There is no tax advantage to naming a trust as the IRA beneficiary. Of course, there may be a non-tax-related reason, such as controlling a beneficiary’s access to money; thus, naming a trust rather than an individual(s) as the beneficiary of an IRA could achieve that goal. However, that is not typically the case.

Generally, trusts are drafted so that IRA-required minimum distributions (RMDs) will pass through the trust directly to the individual trust beneficiary and, therefore, be taxed at the beneficiary’s income tax rate. However, if the trust does not permit distribution to the beneficiary, RMDs will be taxed at the trust level, which has a tax rate of 37% on any taxable income in excess of $12,950 (2020 rate). This high tax rate applies at a much lower income level than for individuals.

Distributions from traditional IRAs are almost always taxable whether they are paid to you or, upon your death, to your beneficiaries. A portion of a traditional IRA’s distributions will be nontaxable if some of the contributions to the IRA weren’t deducted on the IRA owner’s tax return when the contributions were made, but this situation isn’t very common.  

Once you reach age 72, you are required to begin taking distributions from your IRA. If your spouse is your beneficiary, he or she can delay distributions until he or she reaches age 72 if your spouse is under age 72 upon inheritance of your IRA. The rules, which changed as a result of legislation enacted toward the end of 2019, are tougher for non-spousal beneficiaries of individuals dying in 2020 or later, since the entire inherited IRA must be distributed to them by the end of the 10th year after the IRA owner’s death.

There are two exceptions to the 10-year distribution rule:

  • A child (but not a grandchild) beneficiary of the deceased IRA owner will receive distributions based on life expectancy but must distribute the entire remaining balance of the IRA within 10 years after the year the child reaches the age of majority (usually 18 or 21, depending on state law).
  • For any individual who is not more than 10 years younger than the deceased or who is disabled or chronically ill, the remaining account balance generally may be distributed over the life expectancy of the beneficiary, beginning in the year following the death of the deceased IRA owner.

Beneficiaries of IRA owners who died before 2020 are allowed to continue to take required withdrawals over their lifetimes.

To ensure that your IRA will pass to your chosen beneficiary or beneficiaries, be certain that the beneficiary form on file with the custodian of your IRA reflects your current wishes. These forms allow you to designate both primary and alternate individual beneficiaries. If there is no beneficiary form on file, the custodian’s default policy will dictate whether the IRA will go first to a living person or to your estate.

These distribution rules, as well as the caution to keep beneficiary designations up-to-date, also apply to employer retirement plans such as 401(k)s.

This is a simplified overview of the issues related to naming a beneficiary and the impact on post-death distributions. Uncle Sam wants the tax paid on the distributions, and the rules pertaining to how and when beneficiaries must take taxable distributions can be very complicated.

It may be appropriate to consult with this office regarding your particular circumstances before naming beneficiaries.