IRA Beneficiary Designations

IRA Beneficiary Designations Common Problems—Easy Solutions

When an IRA is inherited by a correctly designated beneficiary who is not the spouse of the former owner, the beneficiary may be able to continue income tax deferral over a period determined by his or her life expectancy. This presents tremendous income tax deferral opportunities for certain younger beneficiaries. A beneficiary who is age 50 may continue income tax deferral over a 34 year period. A beneficiary age 25 may continue income tax deferral over 58 years. This opportunity is lost if the former owner did not correctly designate his or her beneficiaries.

If an IRA passes to the estate of its creator, rather than an identified beneficiary such as one or more named individuals or a trust (under certain circumstances) with one or more named individuals as beneficiaries, the IRS will deem that no beneficiary exists, regardless of what the IRA owner’s estate plan might say. This will happen if the estate is actually named as the beneficiary or if no beneficiary is designated at all. When an IRA passes to the estate of its creator, the income tax deferral opportunities available to the beneficiaries of the estate are limited and depend on the age of the account owner at death:

Death before age 701⁄2: Account must be paid to estate beneficiaries within five years of death and income taxes paid.

Death after age 701⁄2: Income tax deferral may be limited. Beneficiaries may extend income tax deferral no longer than the remainder of the decedent’s life expectancy. Example: 78 year old dies with no “designated” beneficiary. Life expectancy of a 78 year old = 11.4 years. 11.4 years is the maximum income tax deferral available to the heirs of the estate.

Contact your Wealth Advisor for more details.

If an IRA passes to the estate of its creator... the IRS will deem that no beneficiary exists, regardless of what the IRA owner’s estate plan might say. Therefore, it is imperative that your IRA has beneficiaries named in a very thoughtful manner.

Some examples of IRA beneficiary designation issues taken from “real life” are:

Example #1

A husband named his wife as the beneficiary of his IRA. When the account was opened, the couple was hesitant to name specific contingent beneficiaries because of the possibility of future children. The husband named his estate as the contingent beneficiary.

Three children and many years later, the wife died. The husband then executed a will leaving his entire estate to his three children. He made no change to his IRA beneficiary designation, assuming that because the IRA will be paid to his estate, which will be controlled by the terms of his will, each child will receive one-third of the account. He was right about that.

The husband died. Because his wife predeceased him, the contingent beneficiary, his estate, became the owner of his IRA. Even though, according to his will, his entire estate will pass to his three children, the IRS will not allow income tax deferral of the inherited IRA over a period based on the children’s lives, because they received these interests through an estate. Length of allowed income tax deferral will depend on whether this death occurred before or after the account owner reached 701⁄2.

Alternative:

Everyone should coordinate with their tax advisor to determine that their IRA beneficiary designations are consistent with their intentions, including:

  • Are there any blank places?
    • Is there a primary beneficiary?
    • Is there a contingent beneficiary?
  • Have any designated beneficiaries predeceased the account owner?
  • Have other circumstances changed since the designation was made?
    • Divorce?
    • Incapacity?

Example #2

Beneficiary designations which contemplate multiple beneficiaries can be tricky. If one party in a set of multiple beneficiaries predeceases the owner, unless contrary intentions are indicated on the beneficiary designation form, only the remaining named beneficiaries take the deceased beneficiary’s share, whether the deceased beneficiary had children or not.

Consider the situation of Mom, who named her four sons as beneficiaries of her IRA with an allocation of 25% each. One son then died leaving three living children.

Mom dies soon after, having failed to change her beneficiary designation. As a result, each living child takes one third of the

IRA. The three children of the deceased son have been disinherited as far as the IRA is concerned.

Is this what Mom wanted?

Alternative:

When naming multiple beneficiaries, consider adding the expression “or issue, per stirpes” after each person’s name. With this extra designation, Hilliard Lyons will be able to distribute the share of a predeceased beneficiary to his or her issue. Please consult with your legal advisor before making this expression. Hilliard Lyons does not offer legal advice and this alternative may not be suitable for all clients or situations.

Example #3

Many people name their children as beneficiaries of their IRAs. They also leave bequests to charities under their wills. In some cases, this has the effect of unnecessarily penalizing both! It’s important to remember that charities generally pay no income taxes, but people generally do.

Consider the situation of the widow who writes a will leaving 10% of her estate to her church and the balance to her daughter. The widow has assets in her name of $900,000. She also owns an IRA of $100,000 with the daughter designated as the beneficiary at her death. In the widow’s mind, she is leaving the church $100,000 and $900,000 to her daughter, but here is what will happen at her death:

  1. The will only controls $900,000, as the IRA passes directly to the daughter so only $90,000 goes to the church. Her daughter will receive $810,000.
  2. Her daughter takes the IRA. Let’s assume her tax rate is 35%. From the IRA, she realizes only $65,000. She also has $810,000 from her mother’s estate for a total of $875,000.

Alternative:

The widow deletes the church from her will but names the church as beneficiary of her IRA. Now at her death, the results will be much better.

Daughter gets the entire $900,000 estate under the terms of the will.

The church, as designated beneficiary of the IRA, will receive the full $100,000 as intended.

Income tax burden is eliminated, providing a bigger bequest to the intended parties.

The examples and alternatives presented herein may not be applicable or suitable for every person. Please keep in mind that Hilliard Lyons does not offer legal or tax advice. Please consult with both your legal and tax advisors before making a decision that may affect your tax or legal situation. If you have any questions regarding these matters, please contact your Hilliard Lyons Wealth Advisor who will be happy to provide more information.

Securities and advisory services offered through J.J.B. Hilliard, W.L. Lyons, LLC, a registered investment advisor and broker dealer. Member NYSE, FINRA & SIPC. Investing in securities involves risk, including possible loss of principal. ©2018. All rights reserved.

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J.J.B. Hilliard, W.L. Lyons, LLC | Member NYSE, FINRA, & SIPC

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