An estate is not the best IRA beneficiary.
Individual retirement accounts are great tools for financially preparing for your golden years.
Under current federal law, who inherits an IRA will impact tax liability.
As a result, it is unwise to name your "estate" as the beneficiary, whether by design or default.
Probate and taxes can quickly burn through portions of wealth when your estate is your IRA beneficiary.
One of the worst IRA estate planning mistakes you could make is listing your estate as your beneficiary or not listing a beneficiary on your IRA.
Both result in legal and financial complications for this asset.
What are the negative results?
Loss of Tax Benefits
Because traditional IRAs grow tax-deferred, the income is not taxed until withdrawn.
Individuals who inherit an IRA can take their disbursements over time.
By staggering their disbursements, beneficiaries can minimize their tax liabilities.
This same benefit is unavailable when an estate rather than an individual is the beneficiary.
When the estate is the beneficiary of the IRA, the account must generally be drained within five years of the account owner's death if the account owner dies before they were required to take withdraws.
Those who inherit after the estate distributes the IRA will have a greater tax burden and may even be forced into a higher tax bracket.
Yikes!
Probate Complications
IRAs are one of a few types of assets with beneficiary designations available.
What does this mean?
IRAs can bypass probate and be transferred directly to the individual named as a beneficiary.
By leaving the asset to your estate, the IRA will be subject to probate.
This can make the settling of your estate longer and more costly.
As a result, your heirs will be left with less of your estate to inherit.
Reduced Flexibility
When an individual inherits an IRA directly, they have more control over the distribution of assets.
There are more rigid rules and timelines when an estate is a beneficiary.
Additionally, when a person inherits via the estate, the individual does not have the option to name a successor beneficiary.
How do estates end up as IRA beneficiaries?
Some people simply neglect to review and update their beneficiary designations.
If a prior beneficiary has died, divorced, or married, it is wise to change the designation.
Other people mistakenly believe their trust or last will would be responsible for the distribution of the IRA and do not know IRA beneficiary designations supersede these estate planning documents.
Lastly, some individuals do not see the benefit of coordinating beneficiary designations for their IRA with comprehensive estate planning.
What are beneficiary options other than your estate?
Name Individual Beneficiaries
Designating a person is better than designating your estate.
You can choose children or a spouse to ensure your heirs benefit from the 10-year or longer distribution rules.
A spouse has the most perks as a beneficiary because he or she can roll your account into his or her IRA account.
Consider a Trust
If you do not believe your family can responsibly manage an inherited IRA, you can leave your asset to a trust.
Although this option allows for more control over the distribution of funds, the trust must be drafted to qualify as a designated beneficiary and avoid tax consequences.
Name Contingent Beneficiaries
Contingent beneficiaries will inherit the asset if your primary beneficiaries die before you do.
By having contingent beneficiaries, you are less likely for your IRA to be funneled to your estate for distribution after you die.
Proactive estate planning and management of your IRA can help you avoid beneficiary issues.
What can you do?
Review Beneficiary Designations Regularly.
Your beneficiary designations should always reflect your wishes.
This means you may need to update them after significant life events.
Coordinate with Your Estate Plan.
Your estate planning attorney can help you understand how your IRA fits into your overall estate plan.
They can direct you on how to align your IRA designations with your last will or trust.
Understand Tax Implications.
Tax law around IRAs can be confusing for the average person.
You can work with a financial advisor to learn how to give your beneficiaries the best tax advantages.
Keep Documents Updated.
The custodian of your IRA should always have your updated beneficiary information.
If you make changes, you must send them to the custodian (on paper or online) for them to take effect.
Although you may believe it easier to make your estate the beneficiary of all your assets, this can lead to complications for your heirs.
If you name individuals or a trust as your beneficiary, you can give your loved ones lower taxes, greater flexibility, and less time in probate.
If you want to create a comprehensive estate plan where your will, trust, and beneficiary designations work together, you can request a consultation with our Estate Planning Law Office in Overland Park.
Taxes are often higher, and flexibility is often lower for IRAs inherited through an estate.
Probating an IRA can complicate life for your heirs and your executor.
People who inherit an IRA directly as beneficiaries can stagger their distributions to minimize their tax liability.
A properly structured trust can also provide tax benefits while allowing your trust administrator more control over beneficiary distributions.
For IRA beneficiary designations to work within a comprehensive estate plan, you should work with an experienced estate planning attorney and regularly review and update your beneficiary designations.
This post is for informational purposes only and does not provide legal advice. You should contact an attorney for advice concerning any particular issue or problem. Nothing herein creates an attorney-client relationship between Harvest Law KC and the reader.
References: Kiplinger (July 27, 2022) "Don't Name Your Estate as Your IRA Beneficiary" and SmartAsset (Nov. 24, 2022) "Estate as Beneficiary of IRA"
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