Managing Your Retirement

Designating IRA Beneficiaries

Managing Your Retirement

Most of us will roll our retirement plan money into a traditional IRA to continue tax deferral when we retire. But of course -- why pay extra income tax when we can delay the bill for many more years? Through years of cussing out the government whenever we look at our paychecks, we've all developed a pretty good set of instincts on not wanting to pay any more in taxes than we have to.

But while most of us are highly cognizant of how taxes affect us through our lifetimes, we tend to forget that any distribution from a traditional IRA is subject to income tax -- even an IRA that's left to our heirs. Thus, the beneficiary selection we make for that IRA has a significant impact on the overall income tax burden to our families. For that reason, your heirs will be eternally grateful to you if you learn the major rules regarding the distribution of traditional IRAs at death.

Spouses

Though it may be the case that really understanding your spouse is one of life's greater challenges, understanding the tax effects of making your spouse a beneficiary of a your traditional IRA is actually pretty simple. A widow may treat a departed spouse's IRA as her own. (The rules apply equally regardless of whether we're talking about widows or widowers here.) As a widow, she may roll her husband's IRA to her own IRA and continue the tax deferral. Easy enough.

Non-Spousal Beneficiaries

All other beneficiaries must take and be taxed on a distribution from an inherited traditional IRA. In essence, non-spousal beneficiaries have two choices on how to take distributions.

  • The Lump Sum: No later than December 31 of the fifth year following the IRA owner's death, non-spousal beneficiaries may cash in the IRA without penalty, pay ordinary income taxes, and keep what's left. This distribution procedure is known as "the 5-year rule."
  • Little by little: Non-spousal beneficiaries may have the IRA proceeds paid out over their own life expectancies and pay ordinary income taxes on the amount distributed each year. The election to have the IRA distributed over their lifetimes must be made and implemented no later than December 31 of the year following the year of the IRA owner's death. If the election is not made by that date (and, hey, that's more than a full year to decide), then all the proceeds must be withdrawn and taxed using the 5-year rule discussed above.

Things to Consider

Until 2001, the designation of a beneficiary for your IRA was extremely important. Why? Taxes, taxes, taxes. Because of large payouts from retirement plans, years of tax-deferred compounding, and successful use of a Foolish investment strategy, there is a lot of money currently stashed away in our collective IRAs. The ability to delay taxation of those proceeds means your heirs will keep more of what they deserve, and the sticky-fingered federal and state governments will just have to keep running lotteries to collect all that they want. Consequently, under old IRS rules, the selection of our beneficiaries was (and to some extent still is) an important decision that we neglected at our family's peril. And that issue is of particular importance when we must begin taking an annual minimum required distribution (MRD) from those IRAs.

Under the old distribution rules, IRA owners who reached age 70 1/2 had to select a beneficiary for those accounts. Then they had to decide whether to take withdrawals from IRAs using a joint or single life expectancy under a term-certain, recalculation, or hybrid method of withdrawal. All of those choices were irrevocable, and they determined how rapidly IRA balances had to be withdrawn by the owner during life or by the beneficiary after the owner's death. Up to eight different methods of calculating MRDs existed. And, choosing the wrong method and/or beneficiary could -- and, unfortunately, often did -- cost the family huge losses to the taxman.

Now, however, most of us can bid adieu and good riddance to those complex choices. The IRS has issued new IRA distribution rules. As of January 1, 2001, those who reach age 70 1/2 (or those who are have already started MRDs based on that age) have a choice of using the new rules or the old ones. "What," you ask, "do the new rules change?" Simply stated, they change a lot. First and foremost, they require the use of one uniform life-expectancy table. That table is based on the account owner's attained age, and it assumes the owner has a beneficiary who is 10 years younger than he or she is. Each year, the account owner finds a factor in that table based on his or her attained age in that year. That factor is then divided into the account balance as of the end of the previous year. The result becomes the MRD the person must take in the new year. The new method for calculating MRDs helps reduce the income taxes due currently, and prolongs both the tax-deferred compounding and the life of the IRAs for almost all families.

Under the new rules, selecting a beneficiary when your MRDs begin is no longer critical. You may now change beneficiaries at will, because choosing a beneficiary will have no impact on how fast your retirement account must be paid out during your lifetime or after you die. In fact, when you finally meet your maker, the actual beneficiary doesn't even have to be determined until December 31 of the following year. That little proviso allows a primary beneficiary (such as a spouse) to disclaim the account in favor of a younger, contingent beneficiary (such as a child or grandchild). The newly named beneficiary could then take MRDs from what's left in the retirement account over his or her life expectancy in that year. Result? A significantly delayed payment of income taxes on the amount in the IRA.

The old MRD rules forced an immediate payout of your IRA at your death whenever the beneficiary you had selected when MRD began was no longer living. That meant a $500,000 IRA, as an example, had to be paid out in one year to surviving children when a spouse, who was the original beneficiary, predeceased the IRA owner. It made no difference the IRA owner had named the children as the new IRA beneficiaries. Now children in a similar situation may elect to have the IRA paid out over their lifetimes, which significantly lessens the income tax impact on that IRA balance to those heirs.

In fact, the only way the life of the IRA can't be prolonged is by your failure to name an IRA beneficiary at all. In that event, and if you had not yet reached your required beginning date for MRDs, the account would have to be paid out to your estate by December 31 of the fifth year following the year of your death. If you die after MRDs have begun, then the account can be paid to your estate over time, based on your remaining life expectancy as calculated as of the year of your death. That life expectancy would be reduced by one in each subsequent year to calculate the subsequent year's payout.

All in all, the new IRA distribution regulations seem to offer superb planning opportunities for families when it comes to how surviving family members must take MRDs from those IRAs. Smile. The IRS just gave all of us a gift. Now let's be Foolish by ensuring we and our heirs understand what that gift means.