Many people spend much of their working lives building wealth in an individual retirement account ("IRA") or a qualified retirement plan such as a 401(k). However, too few of them consider the tax consequences of passing IRA assets to their spouse or family. Without proper planning, a large portion of your IRA may be paid to the IRS instead of passing to your spouse or family.
Let's review some basic rules about IRAs and taxes. Distributions you take from your IRA are subject to income tax during your life. After death, your beneficiaries will pay income tax on distributions as well. Additionally, an IRA may be subject to the estate tax if your estate exceeds the estate tax exemption amount, unless your spouse, a qualified marital trust, or a charity is designated as the beneficiary.
Unlike most other assets, an IRA is distributed in accordance with a beneficiary designation form and not under your will. Some planning with that form can yield significant income and estate tax savings for you and your family. Outlined below is a brief discussion regarding some of the consequences associated with naming the beneficiaries of an IRA.
Spouse. If you are married, designating your spouse as the beneficiary of your IRA is the most common approach and offers a great deal of flexibility. For qualified plans (not an IRA), the participant must obtain the consent of his or her spouse to name a non-spouse beneficiary.
When your spouse receives the IRA, he or she may elect to "rollover" your IRA with no estate or income tax at that time. Your spouse will not have to begin taking distributions until April 1 of the year after he or she attains the age of 70½.
If estate taxes are a concern, consider naming your spouse as the primary beneficiary with your children or a "bypass" trust under your will as the contingent beneficiary. Designating the beneficiaries in this manner gives your spouse the flexibility to analyze the estate tax situation at the time of your death and to decide whether to rollover the IRA or disclaim the IRA. Disclaiming the IRA allows your spouse to utilize your estate tax exemption amount and reduce estate taxes upon the surviving spouse's death. Designating a marital trust for the benefit of a surviving spouse may be desired if there is a second marriage or if you want to control the disposition of the IRA upon the surviving spouse's death.
Children or a trust. If there is no surviving spouse and you are survived by children, you may want the IRA to pass to your children. If your children are adults, they can be named as the outright beneficiaries. However, if your children are minors, it is advisable to name a trust for the benefit of the minor children as the beneficiary.
Generally, each child will have to take out minimum distributions from the IRA over the child's life expectancy. However, it is important to review the plan document, especially with a qualified plan other than an IRA, to determine whether lifetime payouts are allowed.
You may designate a trust with your children as the beneficiary, a bypass trust as the beneficiary to utilize your estate tax exemption amount, or a marital trust as the beneficiary. Generally, if the trust is drafted properly and certain procedures are followed, the funds in the IRA may be distributed over the lifetime of the oldest beneficiary of the trust. This assumes that the plan document permits the lifetime payout.
Charity. If you intend to give assets to a charity that qualifies as a 501(c)(3) tax-exempt organization, using the IRA for this purpose is efficient from an income tax standpoint. The reason is that the qualified charity will be able to receive the IRA without having to pay an income tax. Designating a charity as the beneficiary also avoids the estate tax.
Estate. Your estate should not be designated as the beneficiary of your IRA. If your estate is designated as the beneficiary, this will increase the taxes. Additionally, the IRA assets may be subject to the claims of your creditors. Designating the appropriate beneficiaries of an IRA can save income and estate taxes. Additionally, there may be nontax reasons to designate a trust as the beneficiary of an IRA in the case of children or a spouse. If you do not designate the proper beneficiary of your IRA, Uncle Sam may be an unexpected beneficiary.
Article originally published in Furman University's The Advisor newsletter, 2011 Issue and is posted with the permission of Furman University. Visit www.furman.edu.