Individual Retirement Accounts (IRAs) allow investments to grow tax-free over time and can be an effective way to pass wealth to future generations. Distributions from an IRA are subject to income tax in the year of withdrawal. Required minimum distributions (RMDs), which are calculated based on the value of your IRA and your life expectancy, must be taken when you reach age 70 ½.
At your death, your IRA passes directly to the beneficiary (or beneficiaries) you’ve selected. These designations should be given serious thought and updated as necessary when your wishes or life circumstances change. IRA funds are subject to both estate tax upon your death and income tax upon withdrawal by a beneficiary.
There are several options and many factors to consider when selecting who will inherit your IRA. You may choose one, or some combination of, the following:
Your Spouse – The tax law provides for unlimited tax-free transfers to your spouse at death, so an IRA left to your spouse won’t be subject to estate tax at your death. However, your spouse must still pay any income tax owed on money withdrawn from the IRA.
Your spouse has the option of rolling your IRA into another retirement account, electing to treat the IRA as his or her own, or holding the account as an “inherited IRA.” These various options may allow your spouse to accelerate distributions from the IRA or to delay minimum distributions based upon your spouse’s financial goals and desires.
However, keep in mind that you and your spouse may have different priorities, such as children from prior marriages or a new spouse if your spouse remarries. Your spouse will have full control over naming the subsequent IRA beneficiaries. If this is a concern, you may want to consider leaving your IRA to a trust or a portion to your children directly.
Your Children, Grandchildren or Other Individuals – You may name another individual as a designated beneficiary of your IRA, but they must follow strict guidelines to ensure the IRA does not become immediately, and unintentionally, taxable to them. Non-spouse beneficiaries may not roll over any distributions from your IRA or roll your IRA into their own retirement account.
Where there are multiple beneficiaries, the RMD calculation is based upon the life expectancy of the oldest owner of the IRA. A younger beneficiary can reduce their RMD by requesting the IRA be split into separate accounts, each with its own RMD calculation. Beneficiaries must be cautious to title the accounts correctly and not mistakenly trigger distribution treatment.
Your Trust – A trust can be the beneficiary of an IRA. The trust document outlines how the funds are distributed and should be drafted in a way that allows the trust to “see-through” to the beneficiary’s life expectancy to calculate RMDs. If not drafted appropriately, the trust may be required to liquidate the IRA sooner than desired.
A trust gives you more control over how funds are disbursed after your death. Downsides are the added expense of separate tax return filings, administration, and attorney fees. Also, any income that stays at the trust level will almost always be taxed at higher rates than an individual. The size of your IRA and your overall estate can help determine whether a trust is worth these additional costs.
Your Estate – Naming your estate as the designated beneficiary of your IRA might sound like an easy way to streamline your estate planning process. However, there are drawbacks of leaving your IRA to your estate.
Estates, unlike people, do not have a life expectancy. The ultimate recipients of the funds will not have the option to withdraw the IRA over their own life expectancy table. In some cases, they could be forced to liquidate the IRA in as few as five years. Naming your estate as beneficiary may also subject the IRA assets to probate which can be costly and time-consuming.
There are circumstances where it may make sense to hold the IRA assets in your estate. For example, if funds are needed to pay estate taxes or other expenses, you may not want your IRA transferred directly to your heirs before these costs are paid.
Your Favorite Charity – If you are planning to make charitable gifts in your will, making those contributions out of your IRA can be a tax efficient option. Your estate will receive a charitable deduction, and thus pay no estate tax, for transfers to charity. Likewise, the charity will pay no income tax on distributions from the IRA.
No one – As mentioned above, amounts held in your IRA at your death will be subject to both income tax and estate tax. By wisely depleting your IRA before your death, your beneficiaries can avoid the double estate and income tax hit on these funds. Common planning tools include qualified charitable distributions or a Roth conversion completed in a year you expect to be in a lower tax bracket.
As with any tax-planning strategy, there is no one-size-fits-all solution and minimizing tax should be only one aspect of your planning goals. We are here to help! Please contact our Family Wealth and Individual Tax Group for help navigating your particular situation.