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Retirement Perspectives

Leaving retirement account assets to heirs other than your spouse triggers a multitude of rules, regulations, and decisions. Here are some things you should discuss with your advisor to ensure that your heirs inherit what you intend them to.

An often-overlooked area of retirement planning is beneficiary planning. It can’t be stressed enough: Completing a beneficiary form is one of the most important administrative steps an account owner can take. But completing the beneficiary form is only the first step; it should be reviewed at least annually to determine whether changes are needed.

Why is beneficiary planning so important? Simple: Retirement assets (IRA, 401(k), 403(b), 457(b) plans) are not subject to probate laws. Instead, named individual(s) on your beneficiary form will inherit your hard-earned retirement nest egg. Failing to designate beneficiaries, or to correctly complete the form may result in your retirement assets being passed on to individuals that you did not want to receive them.

If you do not name a beneficiary, the IRA agreement governs, and that could create a default beneficiary designation, such as your estate, that may not be what you desire.

In community property states, if an IRA account owner is married, the beneficiary automatically is the owner’s spouse. Whereas, with ERISA- covered plans (such as 401(k) plans), your spouse is automatically your named beneficiary, regardless of where you reside. Changing your beneficiary to someone other than your spouse in an ERISA-covered plan generally requires the spouse’s written consent. That individual must then be indicated on the beneficiary form.

This article will discuss non-spouse beneficiary-planning guidelines. The Q&A covers some of the questions most frequently asked by IRA account owners and their financial professionals.

Q. As an IRA owner, who can you name as your account’s beneficiary?
A.
You can name anyone you want to as your beneficiary, including children, parents, relatives, and friends. You even can name nonpersons, such as charities. Moreover, there are no restrictions on the number of designated beneficiaries or the amounts left to them.

Account owners residing in community property states may need to obtain spousal consent prior to naming a beneficiary other than their spouse. Your IRA custodian will provide you with a beneficiary form  on which you make the designation, and it then becomes your obligation to keep it up to date as life dictates.

Q. What options do non-spouse beneficiaries have upon inheriting an IRA?
A.
The beneficiaries need to make decisions on how and when to take distributions from the inherited IRA. Non-spouse beneficiaries generally have three options for handling the proceeds:

  1. Liquidate the IRA. The entire amount then will be subject to federal income tax and state income tax if applicable. An early 10% distribution penalty is not assessed.
  2. Begin taking minimum distributions (based on the beneficiary’s life expectancy) by December 31 of the year following the year in which the account owner died. This option is commonly referred to as a Stretch IRA
  3. Defer distributions until a later date; but then the account must be fully distributed by December 31 of the fifth anniversary year of the original account holder’s death. This option is referred to as “five -year payout” rule. No minimum withdrawals are required during the five-year period. 

Tip: Should you inherit a 401(k), understand that most 401(k) plans don’t offer lifetime distributions (i.e., “stretch”) and instead default to the five-year payout, so it is important to be familiar with the plan’s rules.

It also is important to note that only a spousal beneficiary may take actual possession of the proceeds— for up to 60 days—without being taxed, before rolling them over into an IRA. Non-spouse beneficiaries do not have this ability, and the assets, once distributed, are taxable immediately and cannot subsequently be rolled over to an IRA. The account effectively is liquidated. Non-spouse beneficiaries who do not want to take a full, taxable, distribution must move the assets to an inherited IRA directly via a trustee transfer. If they take possession of the proceeds for any amount of time, they will be taxed.

If a nonperson, such as a charity, also is named as one of the primary beneficiaries, it is important to have the nonperson’s portion distributed by September 30 of the year following the death of the account owner. Failure to do so will result in the human beneficiaries being locked into the five-year payout rule described above.

Q. How does a non-spouse beneficiary establish an Inherited IRA?
A. 
Consult with your advisor or contact your existing IRA custodian for information. In general, the beneficiary completes paperwork authorizing the establishment of an inherited IRA. The account should be registered using the beneficiary’s Social Security number, not the deceased’s. The inherited IRA should be registered as follows:

  • Name of deceased and date of death
  • FBO: Name of beneficiary and Social Security number

Q. Which required minimum distribution (RMD) rules apply to non-spouse beneficiaries?
A.
Whether there is one beneficiary or a multiple, the required minimum distribution amount remains the same. Differences may arise, however, in which life expectancy to use in the calculation, because it depends on the ages and types of beneficiaries named

First, determine what the age of the oldest or only beneficiary will be in the year following the death of the original account holder. That age has a corresponding life-expectancy factor drawn from the Single Life Expectancy Table, found in IRS Publication 590 Individual Retirement Arrangements.

For example, the life expectancy of a 45-year-old beneficiary is 38.8 years. The account balance on December 31 of the prior year is divided by this factor (38.8) to determine the minimum distribution amount for that year. The process repeats each year as the life-expectancy factor is reduced by one (37.8, 36.8, 35.8, and so on), while the year-end account balance is adjusted. The life expectancy of the oldest beneficiary is imposed on all beneficiaries, regardless of their age, unless the accounts are “split.”

It is recommended that beneficiaries designate their own beneficiaries to receive the balance of their payments should they not survive the full payout term. A new or second beneficiary would continue taking distributions where the prior one left off. For example, if the first beneficiary in this hypothetical example passed away after receiving one payment, his beneficiaries would use the 37.8 factor (38.8  minus 1) to determine the minimum to be distributed each year. A factor of 36.8 would be used in the following year, and so on. In other words, second-generation beneficiaries cannot use their own life expectancy. Instead, they are required to use the remaining life expectancy of the original beneficiary.  

Note that a beneficiary generally can take more than the minimum withdrawal amount.

Q. What if there are two or more named beneficiaries?
A.
When there are two or more named individual beneficiaries, each can choose to transfer the proceeds over to separate inherited IRA accounts (referred to as “splitting”). As long as each beneficiary establishes a separate inherited IRA prior to December 31 of the year following the original account holder’s death, each beneficiary is able to utilize his or her own age for purposes of stretching the RMD payouts. If the accounts are not “split” by December 31 of the year following the account owner’s death, minimum withdrawals are required, and calculated by using the life expectancy of the oldest beneficiary.

Q. What happens when a minor is a designated beneficiary?
A.
When minors are named beneficiaries, the options and minimum distribution requirements are exactly the same as a named adult beneficiary. For example, a 12-year-old sole primary beneficiary would use the life expectancy for a 12-year-old (70.8 years) to determine the initial minimum distribution amount.

A minor beneficiary, however, can become problematic, since the IRA provider cannot distribute the proceeds directly to a minor, who is not able to make tax decisions. Therefore, it is wise for the account owner to create a trust for the benefit of the minor. The trust would be the named beneficiary. The trustee would be responsible for making decisions (e.g., tax, investments, etc.) on behalf of the minor. In the absence of a trust, the IRA custodian could not make any distributions from the account until a guardian is authorized by the probate court (generally determined by state law).

Tip: Account owners should not move their IRA assets into the trust or retitle their IRA into the name of the trust while they are still alive. Why? These actions are deemed taxable events, and, therefore, the owners will owe income tax on their entire IRA account value. (Ouch!) Instead, the trust simply should be named as the original beneficiary on the beneficiary form

Q. What are some potential pitfalls a non-spouse beneficiary should be aware of?
A.
As a non-spouse beneficiary, you are not permitted to:

  1. Take a distribution via a 60-day rollover. Instead, assets must be moved immediately via a direct trustee transfer.
  2. Convert an inherited traditional IRA to an inherited Roth IRA. Only spousal beneficiaries are allowed to do this.
  3. Roll over an inherited IRA to your own IRA. Instead, an inherited IRA must be kept separate from your own IRA, assuming you have one.

One of the biggest tax advantages available to retirement plan owners is the ability to preserve and pass on the tax status of the accounts that are inherited. However, this golden opportunity can be forfeited if the beneficiary forms are either not in good order or not completed. A minor plan error or oversight can end up costing heirs significantly. We urge investors to meet with their advisors to review and update their beneficiary forms on all retirement accounts as often as necessary. We recommend to advisors that they periodically initiate the discussion with clients.

For more information please go to our retirement section.  


Roth IRA—This is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

SEP IRA—A Simplified Employee Pension Plan is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee's SEP-IRA.

SIMPLE IRA—A Savings Incentive Match Plan for Employees’ IRA is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or non-elective contributions. All contributions are made directly to an Individual Retirement Account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

Traditional IRA—This is an individual retirement savings account in which contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

Minimum distributions must be taken from traditional IRAs by April 1 following the year that a person turns 70½.  A minimum distribution must be taken from the IRA in each subsequent year.  Failure to take the required minimum distribution will result in a 50% penalty on the amount that was not distributed.  Mandatory distributions that represent deductible contributions and all earnings are taxed as ordinary income.  Mandatory distributions based on nondeductible contributions are tax-free.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

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