Understanding
Who Should Be Beneficiary of Your IRA
How to Turn a Modest Inheritance Into Millions for Your Family.
1. Introduction
2. Don't I have to use this money for my retirement?
3. How much will I have to take out?
4. Doesn’t my beneficiary affect my distribution?
5. Whom can I name as beneficiary?
6. Option 1: Spouse
7. How does the spousal rollover option work?
8. What happens if my spouse dies first?
9. Are there any disadvantages of naming my spouse?
10. Option 2: Children, Grandchildren, Others
11. Are there any disadvantages?
12. Option 3: Trusts
13. Are there any disadvantages?
14. Option 4: Charity
15. Option 5. Split Your IRA Into Smaller Ones
16. What are estate taxes and why should I care?
17. What can I do about estate taxes?
18. How can splitting my IRA help?
19. What if I'm not married?
20. When can I change my beneficiary?
21. What about the new Roth IRA?
22. Do I need professional assistance?
1. Introduction
How would you like to turn your modest tax-deferred account into millions
for your family? Depending on whom you name as beneficiary, you can keep
this money growing tax-deferred for not only your and your spouse’s
lifetimes, but also for your children’s or grandchildren’s
lifetimes. That can turn even a modest inheritance into millions.
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2. Don't I have to use
this money for my retirement?
When you reach a certain age, usually 70 1/2, Uncle Sam says you must
start taking your money out. (This is called your required beginning date.)
But if you don’t use all this money before you die, naming the right
beneficiary can keep it growing tax-deferred for decades.
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3. How much will I have
to take out?
Calculating the amount you must withdraw each year (your required minimum
distribution) is much easier now than it used to be. Each year, you divide
the year-end value of your account by a life expectancy divisor from the
Uniform Lifetime Table (provided by the IRS). The result is the minimum
you must withdraw for that year. You can always take out more.
For
example, the divisor at age 70 is 27.4. If your year-end account balance
is $100,000, you divide $100,000 by 27.4, making your first required minimum
distribution $3,650. Each year the divisor is smaller, but it never goes
to zero. Even at age 115 and older, the divisor is 1.9. “To recalculate
or not to recalculate” is no longer an issue. Everyone now gets
the benefit of recalculating their life expectancy.
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4. Doesn’t my beneficiary affect my distribution?
Not any longer. Now, almost everyone uses the same chart to calculate
distributions, even if you have no beneficiary. After you die, distributions
are based on your beneficiary’s life expectancy (or the rest of
your life expectancy if you die without one.) Naming the right beneficiary
is still critical to getting the most tax-deferred growth. That’s
much easier to do now, because you are no longer locked into the beneficiary
you name when you take your first distribution.
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5. Whom can I name as
beneficiary?
You have five basic options: your spouse (if married); your children,
grandchildren or other individuals; a trust; a charity; or some combination
of the above.
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6. Option 1: Spouse
Most married people name their spouse as beneficiary. And, in most cases,
this will be your best option, because 1) the money will be available
to provide for your surviving spouse and 2) it gives you the spousal rollover
option.
Also,
if your spouse is more than ten years younger than you are, you can use
a different life expectancy chart that makes your required distributions
even less. (This lets the tax-deferred growth continue longer on more
money.)
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7. How does the spousal
rollover option work?
If you die first, your surviving spouse can “roll over” your
tax-deferred account into his/her own IRA, further delaying income taxes
until he/she must start taking required minimum distributions at age 70
1/2.
When
your spouse does the rollover, he/she names a new beneficiary, preferably
someone much younger, as your children and/or grandchildren would be.
After your spouse dies, the beneficiary’s actual life expectancy
can be used for the remaining required minimum distributions. The results,
shown in the chart below, can be phenomenal.
For
example, let’s say your grandson is 20 when he inherits a $100,000
IRA from your spouse. Over the next 63 years (the life expectancy of a
20-year-old), the $100,000 IRA can provide him with over $1.7 million
in income!
Under
current IRS policy, your spouse can do this rollover and stretch out the
IRA even if you had started taking required minimum distributions before
you died.
TOTAL
INCOME FROM IRA OVER BENEFICIARY'S LIFETIME*
Age
(20), Life Exp. (63.0)
Value of IRA When Inherited by Beneficiary ($50,000) = $882,865
Value of IRA When Inherited by Beneficiary ($100,000) = $1,765,731
Value of IRA When Inherited by Beneficiary ($500,000) = $8,828,658
Age
(30), Life Exp. (53.3)
Value of IRA When Inherited by Beneficiary ($50,000) = $526,612
Value of IRA When Inherited by Beneficiary ($100,000) = $1,053,225
Value of IRA When Inherited by Beneficiary ($500,000) = $5,266,128
Age (40), Life
Exp. (43.6)
Value of IRA When Inherited by Beneficiary ($50,000) = $321,210
Value of IRA When Inherited by Beneficiary ($100,000) = $642,421
Value of IRA When Inherited by Beneficiary ($500,000) = $3,212,106
Age
(50), Life Exp. (34.2)
Value of IRA When Inherited by Beneficiary ($50,000) = $201,067
Value of IRA When Inherited by Beneficiary ($100,000) = $402,134
Value of IRA When Inherited by Beneficiary ($500,000) = $2,010,671
*
Assumptions: 7% annual return; only required minimum distributions withdrawn.
Income subject to income taxes.
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8. What happens if my
spouse dies first?
If you don’t remarry, you lose the rollover option. (It is only
available to spouses.) This used to be a problem, because distributions
after your death would still be based on your and your deceased spouse’s
life expectancies. But now you can name a new beneficiary, and after you
die distributions will be based on the new beneficiary’s life expectancy.
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9. Are there any disadvantages of naming my spouse?
Your spouse will have full control of this money after you die and is
under no obligation to follow your wishes. This may not be what you want,
especially if you have children from a previous marriage or feel that
your spouse may be too easily influenced by others after you’re
gone.
Also,
if your spouse becomes incapacitated, the court could take control of
this money. It could be lost to your spouse’s creditors. And, finally,
naming your spouse as beneficiary can cause your family to pay too much
in estate taxes. (More about this later.) If any of this concerns you,
keep reading.
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10. Option 2: Children, Grandchildren, Others
If your spouse will have plenty of assets after you die, if you have reason
to believe your spouse will die before you, or if you are not married,
you could name your children, grandchildren or other individuals as beneficiary(ies).
This
will let you stretch out your account without the spousal rollover. Remember,
after you die, the distributions can be paid over your beneficiary’s
life expectancy.
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11. Are there any disadvantages?
Anytime you name an individual as beneficiary, you lose control. After
you die, your beneficiary can do whatever he/she wants with this money,
including cashing out the entire account and destroying your carefully
made plans for long-term, tax-deferred growth. The money could also be
available to the beneficiary’s creditors, spouses and ex-spouses.
And there is the risk of court interference at incapacity. If any of this
concerns you, consider using a trust.
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12. Option 3: Trusts
Naming a trust as beneficiary will give you maximum control over your
tax-deferred money after you die. That’s because the distributions
will be paid not to an individual, but into a trust that contains your
written instructions stating who will receive this money and when.
For
example, your trust could provide income to your surviving spouse for
as long as he or she lives. Then, after your spouse dies, the income could
go to someone else. The trust could even provide periodic income to your
children or grandchildren, keeping the rest safe from irresponsible spending
and/or creditors.
While
you are living, the required minimum distributions will still be paid
to you over your life expectancy. After you die, the required distributions
can be paid to the trust over the life expectancy of the oldest beneficiary
of the trust.
The
trustee can withdraw more money if needed to follow your instructions,
but the rest can stay in the account and continue to grow tax-deferred.
You can name anyone as trustee, but many people name a bank or trust company,
especially if the trust will exist for a long period of time.
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13. Are there any disadvantages?
You will not be able to provide for your spouse and stretch out the tax-deferred
growth beyond your spouse’s actual life expectancy. That’s
because you must use the life expectancy of the oldest beneficiary of
the trust which, in this case, would probably be your spouse.
Also,
many trusts pay income taxes at a higher rate than most individuals, but
this only applies to income that stays in the trust. (If you have a revocable
living trust, this would only happen after you die.) Distributions from
your tax-deferred account that are paid to the trust are subject to income
taxes. And if the money stays in the trust, the higher tax rates would
apply. But usually this is not a problem because the trustee distributes
the money to the beneficiaries of the trust, who pay the income taxes
at their own rates.
Finally,
the trust must meet certain IRS requirements, including that it is a valid
trust under state law.
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14. Option 4: Charity
If you are planning to leave an asset to charity after you die, a tax-deferred
account can be an excellent one to use. That’s because the charity
will pay no income taxes when it receives the money. And the account will
not be included in your taxable estate when you die, reducing the amount
your family may have to pay in estate taxes. (More later.)
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15. Option 5. Split
Your IRA Into Smaller Ones
You don’t have to choose just one of these options. You can split
a large IRA into several smaller ones and name a different beneficiary
for each one. (If your money is in a company plan, you can roll it into
an IRA and then split it.)
If
you name several beneficiaries for one IRA, you must use only the oldest
beneficiary’s life expectancy. But with separate IRAs (one for each
beneficiary), you can use each one’s life expectancy, giving you
the maximum stretch out.
This
is especially important if a charity is involved. It has a life expectancy
of zero, so the IRS would consider it the oldest beneficiary. Depending
on when you die, this could cause the entire IRA to be paid out in just
five years.
If
you divide your IRA now, you will need to calculate a distribution for
each IRA, but it can be worth the trouble. Under the new rules, your IRA
can be divided even after you die. Splitting a large IRA can also save
estate taxes.
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16. What are estate taxes and why should I care?
Estate taxes are different from, and in addition to, income taxes. When
you die, your estate will have to pay estate taxes if its net value (including
your tax-deferred accounts) is more than the amount exempt at that time.
In 2002 and 2003, the estate tax “exemption” is $1 million.
Every dollar over $1 million is then taxed, starting at 41%.
Estate
taxes must be paid in cash, usually within nine months of your death.
If money must be withdrawn from a tax-deferred account to pay the estate
taxes, the result can be disastrous, because income taxes must be paid
on the money that is withdrawn to pay the estate taxes.
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17. What can I do about
estate taxes?
You can reduce your taxable estate by giving some assets to your loved
ones now. You can buy life insurance to pay estate taxes at a reduced
cost. And, if you are married, make sure you use both your estate tax
exemptions.
You
see, everyone is entitled to an estate tax exemption. But many married
couples waste one when they leave all their assets to each other. Currently,
you can leave your spouse an unlimited amount of assets when you die and
there will be no estate taxes at that time. But when your spouse dies
later, he or she will only be entitled to one exemption. That can cause
your family to pay too much in estate taxes.
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18. How can splitting my IRA help?
Any assets you own (including a tax-deferred account) that you leave to
anyone other than your spouse (your children, grandchildren or a trust)
can use your exemption. Splitting a large IRA into smaller ones will make
this easier to do.
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19. What if I'm not married?
If you are single, naming a beneficiary(ies) will be less complicated
because you have just one estate tax exemption and there will be no spousal
rollover option to consider.
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20. When can I change
my beneficiary?
Under the new rules, you can change your beneficiary at any time while
you are living, and the distributions after you die will be paid over
that beneficiary’s life expectancy.
In
fact, now your final beneficiaries do not have to be determined until
September 30 of the year after the year you die, which allows for some
neat “clean-up” planning to be done after you’re gone.
For example, your spouse could “disclaim” some benefits so
a grandchild could inherit. No new beneficiaries can be added after you
die; you must have the right beneficiaries named on your account before
then.
Some
employer-sponsored plans (401(k), pension or profit sharing plans, etc.)
have restrictions on beneficiary options. If your plan will not let you
do what you want, rolling your money into an IRA will usually give you
more options. If your money is in an IRA and the institution will not
agree to your wishes, move your IRA to one that will.
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21. What about the new
Roth IRA?
If you qualify, you may want to convert some or all of your tax-deferred
money into a Roth IRA. You’ll have to pay income taxes on the amount
you convert, but it can be well worth it. If you qualify, you can also
set up a new Roth IRA and make after-tax contributions to it.
Unlike
a traditional IRA that requires you to start taking money out at 70 1/2,
with a Roth IRA there are no required minimum distributions during your
lifetime. And, generally, after five years or age 59 1/2 (whichever is
later), all withdrawals are income tax-free. So you can leave your money
there, growing tax-free, for as long as you wish.
You
can stretch out a Roth IRA just like a regular IRA. After you die, distributions
can be paid over the actual life expectancy of your beneficiary. Your
spouse can even do a rollover and name a new beneficiary. And, remember,
all distributions to your beneficiaries will be income tax-free.
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22. Do I need professional
assistance?
Yes, especially if you have a sizeable amount in tax-deferred plans and
your estate is large enough to pay estate taxes. The rules are still complicated
and loaded with tax traps and penalties. Also, any time you name someone
besides your spouse as beneficiary, you need expert advice.
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NOTE:
This information is designed to provide a general overview with regard
to the subject matter covered and is not state-specific. The authors,
publisher and host are not providing legal, accounting or any other advice
which purports to be specific to your situation. The contents of this
website are believed to be completely reliable. Nevertheless, some material
may be affected by changes in the laws or interpretations of such changes
since the material was entered on the website. If legal advice or other
expert guidance is required, the services of a competent professional
in the field of law, accounting, insurance or investments should be sought.
Price
& Farrington, PLLC - Attorneys and Counselors
at Law
12501 Bellevue-Redmond Road, Suite 215 ....Bellevue,
Washington 98005
Phone: 425.451.3583.. Fax: 425.452.0153 ..E-mail: contact@pricefarrington.com
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