IRA Beneficiaries

When everything works right after an IRA’s owner dies, a named beneficiary takes over their IRA. Unfortunately, sometimes a living beneficiary is not available. What often happens is a husband and wife set up an IRA and they name each other as beneficiaries. When the first spouse dies there is no problem because the surviving spouse takes over the deceased spouse’s IRA.

The troubles begin when the the surviving spouse dies, unless secondary beneficiaries have been named. If secondary beneficiaries are not named or a “non person” is named as a secondary beneficiary, problems can occur, and the heirs can lose a lot of money.

Things can get very confusing when no living beneficiary is listed. Normally, IRAs are not probated, because they are actually trusts. The beneficiaries should be named in the IRA paperwork: it all depends on the IRA agreement. Most IRA agreements have a primary beneficiary and then contingent or secondary beneficiaries named in the trust document. No IRA custodian should ever allow an IRA to be established without naming at least a primary beneficiary. You can name any person or entity as the beneficiary.

If the IRA is “left” to a living person, that person can receive an “inherited IRA.” An inherited IRA can be “stretched” over the new person’s lifetime. The person named as the beneficiary does not have to take the money out of the IRA and it can continue to grow in the tax preferred or tax free environment of the IRA. This is a huge deal for the beneficiary.

The most common scenario for an IRA is to have the spouse named as the primary beneficiary and then have the children named as contingent beneficiaries. You do not want to name your living revocable trust or your estate as a beneficiary, unless you don’t have anyone else to designate as a beneficiary. If you are in that position and don’t have a warm blooded beneficiary and your IRA is large, I’m up for adoption. Actually, that might not work, because attorneys are generally not warm blooded.

When an IRA has the owner’s estate named as the beneficiary, the IRA will have to be probated and passed either according to the owner’s will or according to the laws of the state if there is no will. Probate can be a very expensive, time consuming, and a public process. Probate should be avoided in most situations. Probate leaves the IRA open to the creditors of the IRA owner. Usually, the owner’s creditors will not have had access to the IRA money. The IRA may end up being distributed to people that the owner would never have wanted to receive the IRA money.

IRAs that pass to an estate or to a living revocable trust have to have the IRA money “paid out” of the IRA within a relatively short time. If the money is paid out of a regular IRA (not a Roth IRA), income taxes will be due on all the amounts paid out. That will be classified as ordinary income. The estate of the owner or the living revocable trust of the owner don’t have a “life,” so it is impossible to stretch the IRA and keep the money growing in the IRA. This could mean thousands of dollars of  tax free growth that your heirs will miss out on. (Advanced Tax Tactics has an entire chapter with information on how to stretch your IRA and save on taxes when an IRA is being transferred to beneficiaries.)

If the spouse of the IRA owner is alive but the IRA is distributed to the estate of the IRA owner, there is another lost opportunity. The spouse of an IRA owner gets special treatment under the IRS code, with an option to have the IRA treated as their own. This would roll over the IRA to the surviving spouse, who can then pass it on to the kids, who can then stretch the IRA. If the IRA is rolled over to the surviving spouse, the surviving spouse does not have to take out distributions until they are 70½. This option for the surviving spouse is lost if the IRA goes to the estate or living revocable trust of the IRA owner.

If  an IRA ends up going to the estate, the IRA is going to be hit three different times. It is going to be hit by the creditors of the estate (including the legal fees for probating the IRA), it will have to pay income taxes on the money distributed from a standard IRA, and the heirs will miss out on any tax free growth that would have come from stretching the IRA.

You should check to see who you have selected as your IRA beneficiaries. Your circumstances may have changed and so your beneficiaries need to change. Did you get divorced and still have your ex listed as the beneficiary of your IRA? Did you get married and forgot to put your spouse as a beneficiary? Did you name your estate as a beneficiary (yes, some people do actually name their estate)? Did you set up your trust as the beneficiary (which has a similar affect as naming your estate)? Setting up an IRA and not going back to review who you have set up as the beneficiaries every few years may cause your IRA to go to someone you no longer wish to get it, or it could cost your heirs a lot of money.

All of this can be avoided by simply making sure that you have several layers of beneficiaries for your IRA. At least make sure you have your spouse first and then your kids or nieces and nephews or grandchildren listed as secondary beneficiaries. If you don’t know who your beneficiaries are or you say, “I think my beneficiaries are…,” then you should contact your IRA custodian and find out who your beneficiaries really are. If you need to change your beneficiaries, it is easy. Ask the custodian (trustee) to send you a “change of beneficiary” form, fill it out, and send it in. After you have made sure your own IRA is set, have your parents check on theirs too (it could be worth a lot of money to you someday). The few minutes it takes could end up allowing you or your parents to pass on thousands, even hundreds of thousands, more to the family.