In order to achieve tax savings and accomplish your goals, you should pay careful attention to naming primary and contingent IRA beneficiaries The laws governing inherited IRAs are complicated and it’s easy to make mistakes. If you want to discuss naming beneficiaries and/or creating a “standalone” trust for your IRA (and other retirement account assets), please let us know. Standalone trusts for IRAs can be especially useful in a second marriage, when minor or disabled beneficiaries are potential beneficiaries and/or when the beneficiary may need protection from creditors or a divorcing spouse.
If you have recently inherited an IRA, or if you expect to inherit an IRA, it’s important to promptly speak with an estate planning attorney, accountant or financial advisor before you make any decisions about dealing with the account. If you’re planning to leave someone an IRA, you’ll want to make sure that person knows what to do so that tax planning options aren’t lost through an innocent mistake.
One advantage of an inherited IRA is that the assets may be able to remain in a tax-sheltered account and grow income tax-free for the time before the assets are withdrawn. If an IRA beneficiary’s financial needs are met independent of the inherited IRA, they may opt to leave the assets in their IRA account for as long as possible.
The exact rules for withdrawal and other considerations depend on the type of IRA (traditional or Roth) and the relationship of the IRA beneficiary (e.g., surviving spouse). A beneficiary can take an immediate lump-sum distribution. But unless this is necessary to pay bills, it’s typically the worst choice income tax-wise.
A beneficiary can promptly disclaim part or all of the IRA assets. The advantage here is that the assets might pass to younger family members who can stretch the distributions out over many more years, thus compounding the income tax benefits. Also, the disclaimer will prevent the inherited IRA from eventually being counted as part of the taxable estate of the disclaiming beneficiary. Of course, a disclaimer makes sense only if the beneficiary doesn’t need the assets to live on. Moreover, the beneficiary can’t choose who will get the account upon disclaimer: the asset passes to the person who would legally be entitled to it if the disclaiming beneficiary hadn’t survived. This is another reason why it is important to carefully consider how you complete the forms by which you name primary and contingent beneficiaries. You’ll want to carefully consider who should be named as contingent beneficiary, so that if the primary beneficiary dies first or chooses to disclaim, the assets will go to the persons you named as contingent beneficiaries.
In any event, a beneficiary needs to act quickly. There are strict time limits for dealing with inherited IRA assets.
If an IRA owner passed away before taking out the required minimum distribution (RMD) for the year in which he or she died, the beneficiary must take out the RMD before the end of the year or face a 50% penalty. In some instances, if someone dies late in the year without taking out the RMD, it’s possible that the beneficiary won’t even find out about the bequest until it’s too late to avoid the penalty.
When an IRA owner considers gifts to be made to one or more charities at death, naming a charity as a beneficiary of a portion or all of the IRA can be an excellent way to minimize income taxes and estate taxes and promote the good work of the charity (see our recent Report from Counsel article “Charitable donations from your IRA could save taxes”).
Finally, if your estate plan involves leaving someone an IRA, it’s critical to make sure your beneficiary designation form is filled out correctly and on file with the IRA custodian. If the account ends up going through your estate rather than directly to the beneficiary, the beneficiary might have to completely empty the account within five years, eliminating many of the tax benefits in the process.