What happens to your Retirement account if you pass away? Retirement accounts offer an advantage in the way they can be passed to your beneficiaries without a costly Trust or extensive Probate of your estate. A beneficiary designation allows you to allocate your hard earned savings to your loved ones in any manner you choose. But, there are pitfalls that should be avoided when designating beneficiaries.
When a beneficiary inherits your IRA, they get the option to 'stretch' the Required Minimum Distributions (RMD). Spousal beneficiaries are able to claim the account as their own (which completely transfers the account into their name—and their time table), take distributions based on the life table of the deceased spouse, or take a more accelerated approach. Non-spousal beneficiaries only have two options—take distributions based on the 5-year time frame (meaning the assets will have to be fully distributed within 5 years) or take distributions based on their own life expectancy (this is generally more beneficial as the tax implication can be better managed).
If you name an Estate or a Trust as the beneficiary of your IRA, there is technically no designated beneficiary (i.e. a real person with a life expectancy). Therefore, the RMD will be accelerated for any and all beneficiaries. As an example, if the decedent had not begun their RMD, the entire IRA would have to be paid out by the end of the fifth year after the year of death (5-year rule) and could cause major tax implications. Or if the decedent had begun their RMD's, the beneficiaries would be required to take the RMD's based on the deceased IRA owner's remaining single life expectancy had they lived. This would basically ensure large distributions, causing major tax implications.
Non-spousal Beneficiaries must maintain the inherited status of the account. If they do not, it will be deemed a withdrawal of the full balance and therefore taxable and the 'stretch' capability of the IRA is lost. If the Inherited account does need to be moved to another financial professional, be certain that this is completed using a direct rollover trustee to trustee transfer.
Contributions to an Inherited account are not allowed (and multiple inherited accounts must be kept separate) in order to maintain their inherited status.If the beneficiary makes a contribution to an Inherited IRA, it ceases to have the inherited status and is then fully taxable.