Many people have a good portion of their net worth invested in one or more individual retirement accounts (IRAs). If you're planning your estate, it only makes sense that you'd want your heirs to get the maximum benefit from your IRA earnings. IRA rules can be used effectively to minimize your descendants' tax burden, but the details are tricky. Consult with a tax professional and make sure your heirs understand their options.
Naming a Beneficiary
Naming an IRA beneficiary is one of the most important things you can do to protect the account. If you do not, the funds automatically pass to your estate. If that happens, creditors can claim the money, your heirs must take the money within five years to avoid penalties, and the money is subject to any applicable estate, capital gains and/or income taxes. IRA beneficiaries are not designated in your will--you must fill out paperwork with your IRA custodian.
Non-spouse beneficiaries have two options: they can take the IRA money in a lump sum or begin receiving required minimum distributions (RMDs). The IRS determines RMDs by dividing the IRA's worth by a beneficiary's life expectancy the year you die. The younger the beneficiary, the smaller the RMDs--and tax-wise, that's a good thing. Beneficiaries who take RMDs can allow the funds to accumulate, tax-free, over the remainder of their lives. Those who take the money in a lump sum pay much more in taxes as they are often bumped into a higher earnings bracket.
Non-spouse beneficiaries do not have the option of making IRA contributions or delaying distributions. But spouses who inherit IRAs can treat them as they would their own retirement funds--and all the ordinary IRA rules apply. The downside of this is that if you were to die before your spouse was age 59-1/2, she would be assessed a 10 percent tax penalty for making early withdrawals. In this scenario, it may be to your spouse's benefit to roll the account into an inherited IRA and begin taking RMDs or withdraw the money in a lump sum.
Traditional vs. Roth IRAs
Though you are not required to take RMDs from your Roth IRA in your lifetime, your beneficiaries are. The good news, though, is that your beneficiaries will have the benefit of income tax-free RMDs if they choose to go that route. Traditional IRAs, which allow you to write off your contributions, are subject to income taxes when you or your beneficiaries take withdrawals. Distributions from both traditional and Roth IRAs may be subject to estate taxes if the inheritance is large enough to qualify.
Your beneficiaries have until December 31 the year following your death to decide what to do with the IRA. If you will one IRA account to multiple people, they have the option of splitting it so each beneficiary can decide on his own what to do with the inheritance. However, IRAs are really only a benefit to your heirs if they choose to take the money over time. When planning your estate, talk to your heirs and make sure they understand this.
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