Selecting Beneficiaries of
Individual Retirement Accounts
By: Kathleen R. Arnold
Sandra L. Clapp & Associates, P.A.
The beneficiary designations on your Individual Retirement Accounts (IRAs) or other tax-deferred retirement plans are among the most important decisions in your estate plan. Who should be named as a beneficiary?
For many, the answer is simple - name your spouse as primary beneficiary and adult children as contingent beneficiaries. However, depending on the situation, selecting the beneficiaries for your IRA can be much more complicated. In addition, there are several common, but avoidable, mistakes that are made regarding IRA beneficiary designations.
Regardless of who you name as the beneficiary of your IRA, there are a couple of general guidelines to follow. It is important that you properly complete and submit the appropriate beneficiary designation form. Your Will or trust does not affect the distribution of your IRA unless the IRA is directed to be received into the estate or trust, which may also cause unnecessary income tax implications. You should also make sure that you name both primary and contingent beneficiaries. The beneficiary designations must be updated as necessary, for example, upon divorce or upon the death of a beneficiary. If there is no named beneficiary, the IRA or plan document will provide a default beneficiary. This default designation may not accurately reflect your planning desires or may have undesired consequences. For example, if the IRA document provides that the default beneficiary is your estate or if there is no designated beneficiary, the IRA must be distributed either based upon the IRA owner’s life expectancy or within five (5) years of the owner’s death depending on the circumstances (this is known as the “no designated beneficiary” rule). Additionally, the IRA will be more easily subject to creditor claims if it is distributed to your estate.
Generally, it is preferable to name individuals as the beneficiaries of your IRA instead of naming a trust. For example, if the trust is not drafted correctly, the trust will not be considered a designated beneficiary and the IRA will be distributed pursuant to the no designated beneficiary rule. Additionally, if there are numerous trust beneficiaries, the distribution of the IRA will be based on the life expectancy of the oldest trust beneficiary.
However, there are circumstances in which it is advisable to name a trust as the beneficiary of an IRA. If you desire to name a minor or individual with special needs as an IRA beneficiary, it may be more appropriate to establish a trust for such beneficiary and to designate such trust as the beneficiary of the IRA. A trust may also be the best method to distribute assets to a beneficiary who has creditors or poor money management skills. The trust can protect the IRA assets from creditors and can protect the stretch-out quality of the IRA by preventing the beneficiary electing to distribute the IRA assets as a lump sum. Whenever possible, it is important to name the particular beneficiary’s trust (instead of the main trust) as the beneficiary to ensure that distribution will be based on the life expectancy of only the beneficiaries of that subtrust. Also make sure that you discuss the implications of naming a trust as beneficiary with your legal and tax advisors.
There can also be benefits to naming a charity as the beneficiary of tax-deferred retirement assets. While other beneficiaries will be required to pay taxes on IRA distributions, a qualified charity will receive the IRA distribution without paying any income taxes. If you are considering devising some of your assets to charity and some assets to your children or other family members, it is often advisable to distributed IRA assets to charity, while transferring assets to your family members that will pass to them with a step-up basis.
This article is not intended to replace legal advice applicable to your situation and should be used only for informational purposes. Consult with your legal or tax advisors before implementing any suggestion contained herein.
Ms. Arnold is an associate attorney with the firm of Sandra L. Clapp & Associates, P.A. and can be reached at firstname.lastname@example.org or (208) 938-2660.