(Note: This article deals with not only IRAs but 401(k) plans and other company retirement plans as well. For simplicity’s sake, we are using “IRA” as a catch-all term to refer to most retirement plans.)
A lot of our clients — in fact, nearly all of them — own an IRA account or two (or three). For these clients, we always double-check one thing in particular, because getting it wrong can spell trouble for their heirs. It’s a simple thing, but you’d be surprised how often it’s overlooked.
Name your beneficiaries! Anyone with an IRA should specify who gets it when they die.
Why is this so important?
For one thing, an IRA does not transfer to heirs by a will. Did you get that? Because many people don’t. Way too many folks don’t realize that using their will to name their children as their IRA beneficiaries, will in fact do no good. More to the point, it will actually create much havoc if this unhappy truth is discovered after your death. The beneficiaries who are named on a beneficiary designation form stand to inherit your IRA. You can see why it’s critical to designate only those you want to inherit. And, yes, we have seen an ex-spouse or two (even a deceased person) named as a beneficiary, so it’s important to not only get your beneficiary designations right the first time, but to keep them current. Life happens.
Another good reason for naming a beneficiary is that your heirs then have the option to receive distributions over their life time with incremental tax payments. (Sometimes called “stretch IRA,” this strategy has attracted attention of revenue-starved Uncle Sam recently. At least for now, it is still alive and kicking.)
If your beneficiary is nameless, your estate becomes the beneficiary by default. An estate, of course, does not have a life expectancy, so spreading distributions over life expectancy won’t work. Without the so-called “stretch IRA”, the estate is required to take all distributions within just a few years. (The “few years” here depends on the age of the IRA owner at death. It can be either 5 years or the life expectancy of the deceased IRA owner as if he or she is still alive. It gets a little complicated so we won’t bore you with details. But the point here is that it would usually be a lot shorter than the life expectancy of your heirs.) This packs a hefty tax hit. In this case, your heirs are accelerating distribution (that is, income), and therefore, income tax, giving Uncle Sam a big chunk of your nest egg. How big? If your account was $1 million, at a 40% tax rate, your heirs will be left with $600,000. Ouch.
The longer your heirs choose to keep the IRA account intact with minimal encroachment, the more they will be able to enjoy continued account growth without income tax, spreading their income tax liability over many years.
Reviewing your IRA beneficiaries from time to time is neither difficult nor time-consuming, and may save your heirs a monster of a headache.
Originally published on December 15, 2015.
Advisory services are offered by Joslin Capital Advisors, LLC, an SEC Registered Investment Advisor.