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Choosing IRA Beneficiaries

Money in an IRA usually passes outside of the owner’s will and is distributed according to beneficiary-designation forms filled out when people open the accounts. (The beneficiaries can be amended at a later time.) Who you name as beneficiary determines who gets the money after you die and how quickly your heirs must withdraw it. Keep in mind that most IRA custodians have default beneficiary provisions built into their plan documents that will apply if there is no beneficiary designation on file. For example, a common default provision provides that if the IRA owner doesn’t designate a beneficiary — or all beneficiaries predeceases the IRA owner or disclaim their interests — the beneficiary will be the surviving spouse or, if none, surviving children in equal shares or, if none, the IRA owner’s estate.

Given the importance of the beneficiary designation forms in disposing of your assets, it’s important to have them reviewed by a legal and / or tax advisor who is knowledgeable about the rules that apply to IRAs, and to integrate it with the rest of your estate plan.

Even so, there’s often “A disconnect between what the saver of the money and the eventual beneficiary expect to do with it,” Reber notes. “Most [inheritors] would have a great deal of difficulty not spending the money.”

The type of IRA beneficiary most likely to take advantage of the “stretch” IRA (life expectancy payout) is an adult with a good job, who has a family, owns a home and is trying to save for his or her own retirement. An Inherited IRA “gives a big boost to their retirement savings, which is usually the biggest gap in their life,” says Reber.

Balancing tax concerns with family needs

Most married people start by naming their spouse as beneficiary. Although that’s a natural inclination, it may not be the most tax-efficient option. For stretch-out purposes, the stretch-out maybe longer if you named a child or grandchild. However, if the beneficiary is a minor, a guardian would have to be appointed to receive the funds.

Naming a beneficiary other than your spouse also makes sense from an estate-planning perspective. If your spouse inherits the IRA, there’s no federal estate tax at that point because of an unlimited marital deduction. But if those assets continue to appreciate there could be substantial federal estate taxes when they pass to the next generation. It is important to note that you should consult with your tax and legal advisors about the potential effects of your state’s community property laws, if any.

Contingent and disclaimer beneficiaries

In addition to choosing the primary beneficiary, it’s also important to select contingent beneficiaries. Your contingent beneficiaries receive the IRA if the primary beneficiary either dies before you or disclaims the inheritance. Disclaimers will be limited by the terms of the beneficiary form — the primary beneficiary cannot designate who will receive the IRA benefits.

If there is no contingent beneficiary named and the primary beneficiary disclaims, the assets may be distributed pursuant to the IRA’s default provisions. If distributed to the estate, it could have “very disastrous” income tax consequences.

Designating a trust as beneficiary

You might be inclined to name a trust as an IRA beneficiary for all the same reasons that you would use a trust in other contexts: to protect assets from creditors, to provide for children who are minors or have disabilities, or to control the cash flow of spendthrifts. (The trust can essentially force them to take advantage of the stretch-out option.)

When there are compelling reasons to name a trust, it’s crucial that it qualify as a designated beneficiary. Only then will the IRS “look through” it and treat its beneficiary as if he or she were directly named as the IRA’s beneficiary. This enables the trust to take advantage of the favorable minimum distribution rules that apply to individual beneficiaries.

There are a couple of potential pitfalls. One is that even if the trust qualifies as a look-through (or see- through) trust, the stretch-out maybe significantly shorter than you would have liked. This could happen if, in a trust with multiple beneficiaries, one is much older than the others. Since the payouts must be based on the life expectancy of the oldest trust beneficiary, that shorter payout period will apply for the younger ones as well.

Another risk of naming a trust is that you may choose trust beneficiaries that prevent the trust from qualifying as a designated beneficiary. This problem commonly arises when people name their estates or a charity as the beneficiary of a trust, which in turn is the beneficiary of the IRA. Since neither is a human being, the trust does not qualify as a designated beneficiary. For example, a trust that says, “Distributions to my wife will be made in the discretion of the trustee for her support, health and maintenance for life, the remainder to the church,” generally won’t qualify for favorable treatment.

In such cases, the trust will still get the money. However, it may be required to take the payout within as little as five years, if the account owner hadn’t reached the required beginning date. A different payout period applies if the owner died on or after this date. In that case a trust without designated beneficiary status can calculate withdrawals according to the account owner’s remaining life expectancy, as if he or she were still alive. This would probably mean a more rapid payout than if the trust could use the life expectancy of the oldest beneficiary to calculate withdrawals.

One more caveat: it’s generally much more tax-efficient to leave an IRA to your spouse outright than through a trust. Here, too, the difference turns on the IRS tables used to calculate distributions. The extremely favorable table that applies to spousal rollovers can’t be used in this context. In calculating distributions based on the wife’s life expectancy, the trust would have to rely on the table that applies to all other inheritors.

Naming a charity as a beneficiary

If you want to leave IRA assets to charity, there are ways to do this without involving a trust, and good tax reasons for doing so.

Most notably, it avoids the two taxes that apply when people inherit IRA assets — income taxes and estate taxes — which together could consume up to 65% of a family’s IRA inheritance. In contrast, a charity, which is tax-exempt, can draw the funds without paying income tax, and the estate can take a charitable deduction for the amount left to charity. Given a choice about how to divide up the assets in their estates, many people who are philanthropically inclined therefore find it more tax efficient to give the IRA to charity and leave their heirs other property.

The simplest way to make the gift is by directly naming the charity in the IRA beneficiary designation form. You can either make the charity a 100% beneficiary of the IRA, or indicate that the charity is a beneficiary of a certain percentage of the IRA, and that the rest should go to individual beneficiaries.

You have a wide range of choices when choosing the charitable entity to receive the IRA gift. It can be any organization that you could make a gift to and take a charitable deduction from income taxes, including: a private foundation, a public charity, a supporting organization, a community foundation or a donor-advised fund.

Your retirement savings may be the primary source of your income when you retire. Southern Wealth Advisors can offer you strategies and guidance to help successfully manage your income in retirement and preserve the wealth you’ve accumulated—for yourself and your heirs.

We are committed to helping you prepare for the future.

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Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Independent Advisors Alliance, a registered investment advisor. Southern Wealth Advisors and Independent Advisors Alliance are separate entities from LPL Financial.

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