In order to save your heirs the burden of paying more income and estate tax than necessary after you are gone it is important to designate a beneficiary for your IRA as a part of your estate plan.
Begin by customizing your IRA beneficiary designation to fit your goals. Generally spouses children grandchildren and other loved ones are commonly chosen to serve in this role. You may also name a trust charity or combination of individuals trusts and charities to fill the role. After your death distributions from your IRA will be required and the person you choose as the beneficiary will dramatically affect the income tax consequences. Here are some important things to consider when completing your IRA beneficiary form.
Name a Contingent Beneficiary
If you have already named a primary individual as the beneficiary you should also name a contingent beneficiary because your primary beneficiary may predecease you. If your IRA does not have a designated beneficiary most plans require your estate to be the default beneficiary which usually produces unfavorable tax results.
IRA benefits payable to an estate must be distributed within five years of your death if you die before your required beginning date (RBD – April 1 following the calendar year in which you reach age 70 1/2) or during your remaining single-life expectancy if you die after your RBD. An individual and certain trusts can enjoy more favorable tax treatment because they are allowed to take required minimum distributions (RMDs) from an inherited IRA over the life expectancy of the individual or of the trust beneficiary. Also as of 2013 an estate will reach its highest income tax bracket (40%) once taxable income exceeds $11950 while an individual must have more than $400000 ($225000 if married filing separately) of taxable income before the 40% rate applies.
Naming Multiple Individual Beneficiaries
When multiple individuals are named as primary beneficiaries such as your kids the oldest beneficiaries life expectancy must be used to determine the RMD from your IRA. This is often referred to as the “oldest heartbeat rule.” If you name your children equally as primary beneficiaries it is best to designate that any deceased child’s share pass to his or her children (your grandchildren). This distribution method often includes the phrase “by right of representation” or the Latin phrase “per stirpes.” You should also specify what happens to the share of a child who predeceases you. State law generally presumes that a bequest to a blood relative automatically passes to that relative’s descendants in such situations however that rule may not apply to an IRA beneficiary designation form. In fact in the case of multiple primary beneficiaries many IRA custodian agreements require that the account be paid equally to class members who survive you unless you specify otherwise. An exception to this rule provides that if the IRA is divided into a separate account for each beneficiary each one may use his or her own life expectancy to measure the RMD. To do this each separate account must be established by September 30 of the year following the year of your death.
Naming Your Living Trust as Beneficiary
An IRA participant with a living trust may consider naming it as the primary or contingent beneficiary. (If married the participant may for example name his or her spouse as primary beneficiary and the living trust as the contingent beneficiary). When you name a living trust as either primary or contingent designated beneficiary be sure that your trust agreement is drawn up properly. If this is done incorrectly the entire account balance may have to be withdrawn within five years of your death. Also if the trust provisions governing how your trust assets will be divided upon your death are not properly drawn up the designation of the living trust as a beneficiary of the IRA may accelerate the income tax on the IRA as income in respect of a decedent.
Oftentimes a participant’s living trust divides into shares when the grantor dies. For example if you have a living trust and the trust agreement provides that on your death the trust assets are allocated and divided equally among your three children is the separate account rule available to your three children as beneficiaries of the living trust? Will the RMD be paid over the life expectancy of the oldest child or will each child use his or her own life expectancy?
The IRA distribution rule says that the separate account rule would not apply here. In order for the separate account rule to apply the allocation and division of the IRA into separate shares for each of the three designated beneficiaries must occur in the IRA beneficiary designation form instead of in the living trust agreement. So if you want shares passing to your children to qualify as separate accounts you must name them (or create separate trusts for them) directly as IRA beneficiaries instead of naming your living trust as beneficiary.
When designating your IRA beneficiary pay careful attention to the tax and non-tax consequences. These rules and regulations can be complicated and may involve tax traps you are unaware of. Lindemeyer CPA is here to help you navigate those difficult and sometimes confusing regulations. If you need assistance setting up an IRA beneficiary or need professional guidance with taxes or accounting issues click here and a member of our team will get back with you shortly. At Lindemeyer we understand complex accounting and tax requirements and we guide you through the process of making decisions from start to finish. Our experienced team of professionals knows how to help.