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Sometimes, the silliest oversights hurt you the most. As unjust as it may seem, dumb little goof-ups can cost you a lot of money.

Take, for instance, your IRA. IRAs are great for saving money for retirement, and if you don't use all of the money in your retirement accounts, then you can pass it on to your heirs.

There are two ways to determine who'll receive your IRA money after you die. The best way is for you to pick them yourself, by using a beneficiary designation form. If you don't name a beneficiary, however -- or if you fill out a form that leaves your IRA to your estate -- then you may have made a huge mistake. It may not seem like a big deal, but based on how the tax laws treat IRA money that goes through your estate, your heirs may miss out on a tax break that could save them thousands of dollars over their lifetimes.

Complex IRA rules
The rules on inherited IRAs differ depending on who's inheriting it. A spouse can roll over an inherited IRA without any complications.

However, anyone else must keep the inherited IRA separate from their own retirement funds. Moreover, they have to start taking withdrawals from the inherited IRA right away, even if they haven't retired or yet turned age 59 1/2. Distributions from inherited IRAs aren't subject to 10% penalties, but they do get included in your taxable income for the year you take the money out.

If you're named on a beneficiary form, you can spread withdrawals over your entire lifetime, based on IRS life expectancy tables. So if you have a life expectancy of 50 more years and inherited an IRA, you would only have to take 2% of the IRA balance in the first year, and that percentage would increase very gradually over the years.

In contrast, if there's no listed beneficiary or the form names the estate, you don't get the option to extend withdrawals over your lifetime. Instead, you'll have a five-year limit during which you must take all the money out.

A big problem for beneficiaries
At first, that may not sound like such a big deal. But there are two downsides.

First, having to withdraw the entire balance of an inherited IRA within just a few years can cause a big jump in taxable income, potentially pushing you into a high tax bracket and costing you far more than you'd pay if you could spread the tax liability out over 40 or 50 years.

Second, the money you lose to taxes not only reduces what you inherit, it also cuts the growth of your inherited IRA. That can prove a much bigger deal over time.

For instance, consider an example where two people inherited IRAs worth $350,000 five years ago, one who was a designated beneficiary, the other who wasn't. The person who wasn't a designated beneficiary would have had to withdraw all the money by now, potentially paying as much as $122,500 in income tax, if he ended up in the highest 35% tax bracket.

But if you were a designated beneficiary, you could leave most of the money in the IRA. If you invested the $350,000 equally in seven different dividend-paying stocks, you could use that income to satisfy the minimum distribution requirements. Assuming that the dividend income was enough to meet those requirements, and that you'd cash out in 20 years, here's what the IRA would grow to, based on historical returns:

Stock

Current Dividend Yield

After 20 Years, $50,000 in Shares
Could Grow To

Chevron (NYSE: CVX  )

4.1%

$228,873

Boeing (NYSE: BA  )

5.0%

$109,917

Home Depot (NYSE: HD  )

4.3%

$852,498

Coca-Cola (NYSE: KO  )

4.0%

$318,995

ConocoPhillips (NYSE: COP  )

5.2%

$152,084

Johnson & Johnson (NYSE: JNJ  )

3.6%

$436,387

Procter & Gamble (NYSE: PG  )

3.4%

$419,842

Source: Yahoo! Finance. Projections based on 20-year average annual return from 1989 to present. Growth of $50,000 excludes effect of dividends, which are assumed to be withdrawn for minimum-distribution purposes.

That adds up to more than $2.5 million. Of course, all that money would still eventually be taxed. But if you just fill out a beneficiary designation form, your heirs will have a lot more control over exactly when they pay taxes -- and can hopefully plan in a manner that cuts their overall tax liability.

So if you have an IRA, make sure you've designated a beneficiary. If you don't, it could cost your family a ton of money -- and cause some big headaches as well.

For more on making the most of your IRA, read about:

Turn to our Rule Your Retirement newsletter to get the inside scoop on using IRAs, 401(k) accounts, and other resources to save as much as you can for retirement. You can see everything we have to offer with a 30-day free trial.

Fool contributor Dan Caplinger has all of his beneficiary designation forms filled out. He doesn't own shares of the companies mentioned in this article. Johnson & Johnson and Procter & Gamble are Motley Fool Income Investor selections. Home Depot and Coca-Cola are Motley Fool Inside Value recommendations. The Fool owns shares of Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy walks easy.


Read/Post Comments (1) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 18, 2009, at 10:33 AM, zmlawyer wrote:

    Additionally, in Connecticut (and maybe other states)if the IRA is payable to your estate, it needs to go through probate and is also available to creditors of your estate, and if your will is contested or you have no will then the IRA may go to beneficiaries you never intended. An IRA with a beneficiary designation bypasses probate and in most cases will not be available to any of your creditors! So make sure you have your IRA beneficiary form in a safe place. In many cases it is more important than your will!

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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