For most people, naming beneficiaries for retirement assets or life insurance policies happens one time – when the account or policy is first started. Typically the named beneficiary is their spouse, after that it’s usually their children, at which point it will most likely never be thought about again. While no one likes to think about death, reviewing your beneficiaries can save your loved ones a lot of time, aggravation, and be an effective estate planning tool to build or maintain wealth over many more years.
Appropriately naming your beneficiaries may be an effective estate planning tool by allowing your money to continue to grow tax deferred over many years and extend your retirement savings after your death. Naming a child or grandchild as the beneficiary allows the required minimum distributions (RMDs) to be calculated over their life expectancy, minimizing the amount of money coming out of the account thus stretching the amount of time the money can grow tax deferred.
Consider Walter, who at age 82 passes away and leaves $100,000 to his granddaughter Gretchen as the designated beneficiary, who is now age six. Gretchen will now begin taking RMDs from her Inherited IRA. The RMDs will be based on her life expectancy and allow the money to grow tax free and be “stretched” over her lifetime. If she continues to withdraw just the RMD each year, and the account appreciates at a rate of 6% per year, the value will increase to $756,994.14 by the time she reaches age 65 plus the $708,156.32 she would have collected in RMDs over the years. If she lives until age 82 her full life expectancy, she would have collected $2,045,616.58 less taxes over that time. That is the power of compounding and a very effective way to grow wealth over many years.
Another major reason for naming beneficiaries is to avoid probate. Probate is the long and expensive process of reviewing your will and assets to determine where they will be distributed upon your death. Making sure your beneficiaries are exactly who you want them to be is important because these named beneficiaries override any distribution requests you may make in a will. Remember you can name as many beneficiaries as you would like; there is no limit to the number of primary or secondary beneficiaries that you can name for any plan.
It is important to note that spouse and non-spouse beneficiaries do not have the same distribution options available to them. The following examples apply to Traditional IRAs but can hold true for Roth IRAs as well with more flexibility regarding ages of distributions and taxability as Roth IRAs are funded with after-tax dollars. For exact details please contact your tax advisor.
Spouse
You have several options, depending on whether your spouse was under or over age 70½ at the time of their passing. If your spouse was over or under 70 ½, there are three options.
- – Lump sum distribution. Money is distributed all at once and taxes will be paid at that time.
- – Transfer the assets into your own existing IRA. In this case you must be the sole beneficiary. The assets will continue to grow tax deferred and any distributions you take before you turn 59 ½ will be subject to a 10% early withdrawal penalty. You also may designate your own IRA beneficiary.
- – Open an inherited IRA. You will be required to take distributions no later than the end of year the account holder would have reached 70 ½. The annual distributions will be calculated based on your life expectancy in the calendar year following the year of death. The assets will continue to grow tax deferred and will not be subject to a 10% early withdrawal penalty. You also may designate your own beneficiary.
There is one other option available but only if your spouse was under 70½.
- – Open an inherited IRA (5 Year Method). Money is available any time up until the end of the fifth year after the year in which the account holder died, at which point all assets need to be fully distributed. Each distribution is taxed however you will avoid an early withdrawal penalty. Also, your assets will still grow tax free over that time period and you can still name your own IRA beneficiaries.
Non-Spouse
For non-spouse beneficiaries the options remain similar but exclude the option to transfer the assets into an existing account of their own. Again, in both situations, your spouse could be over or under 70 ½, there are two options.
- – Lump sum distribution. Money is distributed all at once and taxes will be paid at that time.
- – Open an inherited IRA. You will be required to take distributions no later than the end of year the account holder would have reached 70 ½. The annual distributions will be calculated based on your life expectancy in the calendar year following the year of death. The assets will continue to grow tax deferred and will not be subject to a 10% early withdrawal penalty. You also may designate your own beneficiary.
And again, only if the account holder was under 70 ½ would you be able to elect a third option.
- – Open an inherited IRA (5-Year Method). Money is available any time up until the end of the fifth year after the year in which the account holder died, at which point all assets need to be fully distributed. Each distribution is taxed, however you will avoid an early withdrawal penalty. Also, your assets will still grow tax free over that time period and you can still name your own IRA beneficiaries.
For all the reasons listed you should at least be reviewing your beneficiaries after a major life event such as marriage, divorce, or the birth or adoption of a child. Another important thing to be aware of is the deadline for setting up accounts and taking distributions. Failing to make sure the account is registered as an Inherited IRA, or failing to set the account up by December 31st of the year following the year the original account holder dies could trigger immediate payouts or the 5-Year Method creating a large tax bill for the beneficiary. Penalties for early withdrawals are 10%, penalties for not taking a large enough distribution may result in a 50% tax on the portion not taken, and failing to take a distribution may initiate the 5-Year Method causing you to lose the stretch benefit.
