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INTRO: Many people have a significant portion of their wealth in their Individual Retirement Accounts (IRAs). Yet, the rules related to inheriting an IRA are often shrouded in mystery. The IRA owner should be sure he or she has primary and contingent beneficiary designations on file with the IRA custodian and that IRA planning is coordinated with his or her estate planning. People inheriting an IRA should obtain legal, financial and tax advice and proceed with great care before taking any action with respect to the IRA being inherited. Here is some good general insight.
Many people establish an Individual Retirement Account (“IRA”) and much is written about these interesting investment vehicles. They are highly touted because they can be funded with pre-tax dollars (i.e. taxpayers can receive a tax deduction for IRA contributions, up to certain limits). Moreover, these accounts are able to grow on a tax deferred basis until funds are withdrawn, subject to certain penalties that can be imposed if the IRA owner withdraws before reaching the age of 59 1/2, and subject to mandatory minimum required distributions the year after the IRA owner turns 70 1/2.
Despite the fact that aging workers and retirees have built up substantial wealth in IRAs, and that IRAs commonly represent a very significant percentage of a person’s total assets, the topic of inheriting IRAs doesn’t receive a lot of media coverage. Even the basic rules and issues involved in inheriting IRAs are sometimes unknown to or misunderstood by IRA owners.
So, what should an IRA owner know and what should an IRA inheritor know about this subject? Below are important pieces of the puzzle, but first a caveat: whether you are an IRA owner or IRA inheritor, be sure to talk to your financial and tax advisors about all relevant details and alternatives before taking any action, as IRA rules and exceptions are many and complex!
1) The beneficiary designation on file with the IRA custodian (i.e. financial institution) at the time of the IRA owner’s death governs who is entitled to inherit the IRA, and the IRA goes to the beneficiary without being subject to probate. The IRA owner’s Living Trust or Will does not control this unless there is no beneficiary designated or no beneficiary alive upon the owner’s death.
2) It is imperative that you confirm that your IRA custodian has a beneficiary designation on file that: a) lists the primary beneficiary(ies) you want to inherit your IRA (and if multiple beneficiaries, the fractional interest to go to each); and b) designates a secondary/contingent beneficiary(ies) – in case the primary beneficiary predeceases you.
3) If you are the designated beneficiary and thus inherit all or a portion of an IRA, you have the choice to: a) continue to own the IRA as an “inherited IRA” or “stretch IRA”, which enables you to enjoy tax deferred growth of the IRA assets over your life expectancy OR b) cash out the IRA, pay all of the deferred taxes and be left with the remaining post-tax funds that will no longer be in a tax-deferred vehicle. Note that spouse beneficiaries have additional options.
4) IRA inheritors choosing to keep an IRA must be very careful in giving instructions to the IRA custodian. If you are not the IRA owner’s spouse, the IRA must not be put into your name or touch your hands in any manner; rather, it must stay in the name of the deceased IRA owner, with you listed as the beneficiary.
5) An IRA owner needs to coordinate estate planning of other assets – e.g. via terms of a living trust and/or a Will – to make sure everything is integrated. Absent such coordination, unintended consequences can occur. For example, suppose a person has a $500,000 IRA and $1.5 Million of other net assets. The IRA owner has a Living Trust that provides for cash gifts of $100,000 to each of his five grandchildren ($500,000 total) and the balance to his children. The IRA owner is under the impression that the $500,000 IRA will satisfy the $500,000 of cash gifts to the grandchildren specified in his Trust. However, if no express language to that effect is stated in the Trust, the result will be that the grandchildren receive the $500,000 IRA from the IRA custodian as the designated beneficiaries and an additional $500,000 in cash gifts from the trustee of the Trust.
6) If you have charitable intent, consider the tax efficiency of designating a charity as beneficiary of your IRA. Unlike with loved ones, the charity will not incur the burden of paying deferred income tax when the charity withdraws the IRA assets.
7) If you have minor or young adult children, you should discuss with your estate planning attorney the pros and cons of naming your Living Trust, rather than the children directly, as beneficiaries or contingent beneficiaries of your IRA.
This article is intended to provide information of a general nature, and should not be relied upon as legal, tax, financial and/or business advice. Readers should obtain and rely upon specific advice only from their own qualified professional advisors. This communication is not intended or written to be used, for the purpose of: i) avoiding penalties under the Internal Revenue Code; or ii) promoting, marketing, or recommending to another party any matters addressed herein.
Mr. Silverman is an attorney with R. Silverman Law Group, 1855 Olympic Blvd., Suite 125, Walnut Creek, CA 94596; (925) 705-4474; rsilverman@rsilvermanlaw.com.
ESTATE & TRUST ADMINISTRATION: Need to find an experienced estate & trust administrator in Walnut Creek CA? Contact Robert Silverman at 925-705-4474 for legal advice on a Revocable Living Trust, “Summary” Estate Administration, Trust/Estate Beneficiary Representation and Will & Trust Disputes.