Establishing and funding an IRA is an important step in achieving the retirement lifestyle your hard work deserves. For many of us, the perfect scenario would be to pass away immediately after spending the last dime in our IRA.
For others, our IRA will be a large portion of our net worth, and we hope to live comfortably in retirement and still be able to pass the balance of our IRA on to our spouse or another loved one.
And even if we prefer the former option, the odds of living exactly as long as the money in our IRA holds out are infinitesimal. Since we fear outliving our money, many of us will spend conservatively and end up leaving a balance in our IRA, regardless of our preference.
If we want to minimize the government’s share and maximize the benefit to our heirs, it is important to make sure we properly complete the beneficiary information for each of our IRAs.
The tax advantage of an IRA is that tax is deferred while the assets continue to grow.
For a traditional IRA, distributions can be deferred until the owner is 70.5, which is when required minimum distributions must start.
For a Roth IRA, distributions can be deferred until the Roth IRA is passed onto the beneficiary.
How quickly or slowly the IRA must be distributed once in the hands of the beneficiary depends on the age of the owner at the date of death, the relationship of the beneficiary to the owner (spouse, non-spouse, or estate) and the age of the beneficiary.
Clearly longer is better, so how can you make the distribution period as long as possible?
For married individuals, the most common beneficiary is the surviving spouse, and there are special advantages for a spouse who inherits an IRA.
Unlike other beneficiaries, an inheriting spouse can choose to treat the IRA as his own by either designating himself as the account owner or by rolling it over into an IRA, a qualified employer plan, a qualified employee annuity plan or a deferred compensation plan of a state or local government.
Once the spouse becomes the owner of the IRA, required distributions are based on the surviving spouse’s life expectancy. If the spouse is younger than the owner, this will stretch the life of the IRA.
The other option for the surviving spouse is to treat himself as the beneficiary of the IRA. Under this option, if the owner was already taking distributions, they must continue using the longer of the spouse’s life expectancy or the owner’s life expectancy.
If not, the distributions will start using the date the owner would have started taking them but using the spouse’s life expectancy. A surviving spouse who chooses this last option should immediately name a successor beneficiary.
If the surviving spouse dies, distributions cannot be recalculated based on the age of the new beneficiary, but probate is avoided and the five-year rule does not come into play.
The five-year rule requires the IRA beneficiaries to withdraw 100 percent of the IRA by Dec. 31 of the year containing the fifth anniversary of the owner’s death.
This rule applies in all cases where the named beneficiary is not a person (i.e. the estate) or when there is no individual named as beneficiary by Sept. 30 of the year following the owner’s death (because the named beneficiary is deceased or disclaimed (refused) the inheritance leaving the estate as the default beneficiary.)
Because the stretch period is only five years, it is the least desirable outcome.
Avoidance of the five-year rule is why if you have no spouse or there are reasons you prefer not to leave your IRA to your spouse, you should name one or more friends or relatives as beneficiaries.
Naming your estate is the least tax effective and thus most expensive way to leave an IRA. Non-spouse individual beneficiaries use their own life expectancies although distributions must start by Dec. 31 of the year following the owner’s death. Naming a young relative will prolong the life of the IRA, but to limit that, the life expectancy of the beneficiary is reduced by one year for each year since the year following the owner’s death.
If there are multiple individual beneficiaries, it is best to divide the IRA into separate accounts by the end of the year following the year of the owner’s death.
This is because each account holder will use her own life expectancy to determine RMDs. If separate accounts are established after that date or if only one account is maintained, the shortest life expectancy of any of the beneficiaries will be used to determine the RMDs.
Everyone with an IRA or a retirement plan should check their beneficiary designations to make sure that those named are still those you would want to inherit (think ex-spouse), that both primary and secondary beneficiaries are named and all are still living and that your estate is not named as a beneficiary.
Anyone inheriting an IRA should seek counsel so important deadlines are not missed. Penalties will be assessed for failure to take RMDs, and opportunities to stretch the payout can be missed if distributions do not start before certain deadlines.
An IRA is a great vehicle for tax-deferred or tax-free investment growth. By properly handling your beneficiary designations and your inherited IRA, you may be able to stretch this benefit well into the future.
Susan Clifford is a principal with Hancock Askew & Co. LLPs. She can be reached at 912-234-8243 or sclifford@hancockaskew.com.