Naming an Estate as the Beneficiary of a
Traditional IRA
It May Not Be The Wisest Choice!
By: Gregory J. Cook, EA, CPA |
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For many individuals, naming a
beneficiary on a Traditional IRA may seem like a mere formality. But negative
tax consequences exist for those who, on the assumption that their assets will
go to their heirs anyway, name their estate as beneficiary instead of an
individual or individuals.
When a Traditional IRA holder reaches age
70 1/2, minimum distributions become mandatory and must begin by April 1st of
the following year. These distributions are based on the life expectancy of the
holder and the named beneficiary if a joint life calculation is selected. (A
joint life calculation is generally viewed as more desirable because the
mandatory payments are lower.)
Once the distribution schedule has been
established it cannot be changed while the Traditional IRA holder is living
except under certain circumstances it may be shortened. If the named
beneficiary is the estate, the distributions cannot be based on a joint life
(the estate does not have a life expectancy). Therefore, the required
distributions will be larger because the life expectancy can only be based on
that of the single Traditional IRA holder. For those clients who do not need
Traditional IRA distributions as a source of income, having to take larger
distributions than absolutely necessary can be frustrating.
When a Traditional IRA holder dies, the
distribution of assets is dependent on whether or not the Required Minimum
Distributions (RMDs) have begun. If the Traditional IRA holder had not yet
reached age 70 1/2 and the RMDs have not begun, the estate is required to take
full distribution by December 31st of the fifth year following the date of
death. If an individual had been named as beneficiary, he/she would have the
option to spread the distributions out over his/her own life expectancy; if the
beneficiary were a spouse, the spouse could elect to roll the assets into
his/her own Traditional IRA. (The spouse is the only beneficiary who can make
this election.) Even though the beneficiaries of the estate will receive their
due in the end, the difference between taking distributions within five years or
enjoying the benefits of tax-deferred growth through their own life expectancy
could be significant.
If a Traditional IRA holder dies after the
RMDs have begun, the way in which those distributions have been calculated
becomes crucial. If the distribution has been recalculated each year, the estate
beneficiary must take full distribution by December 31st of the year following
the date of death. This is because re-calculation requires that the life
expectancy be "re-calculated" from the IRS Life Tables each year, and when the
Traditional IRA holder dies, his/her life expectancy drops to zero. Therefore,
the entire balance must be distributed within the year. If the Traditional IRA
holder had not been re-calculating and had been using the "elapsed years method"
(also referred to as "term certain method"), the estate is permitted to
continue using the same method or distribute at least as rapidly under another
method.
The taxation rules applicable to estates
and distributions are exceedingly complex. If you have named your estate as
beneficiary, the beneficiary designation can be changed up until the point at
which RMDs begin. There may, however, be some very good reasons why a tax
attorney may advise you to leave an estate beneficiary intact. Therefore, it's
important to make certain that you are taking advice from a qualified expert in
the estate planning area.
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