How to Leave an IRA to Heirs
December 22nd, 2022
Retirement assets, including Individual Retirement Accounts (IRAs), often make up a large part of a deceased person’s estate. Retirement accounts are also, unfortunately, one of the biggest sources of estate-planning errors. The rules about distributions for inherited IRAs have changed in the past few years, heaping more confusion onto an already complicated situation. If you have an IRA, and you want to leave it to your loved ones after you’re gone, there is some important information you need to know.
You Can’t Leave an IRA to Your Heirs in a Will
You can certainly leave your IRA to your spouse, children, or other family members. But unlike many other assets, your will is not the way to do it. An IRA is an asset that passes outside of probate through a beneficiary designation on the account.
Unlike a 401(k), which requires your spouse to sign off on your naming someone else as the beneficiary, you can leave your IRA to anyone you want. Leaving an IRA to a charity, leaving an IRA to your grandchildren—it’s entirely up to you. All you have to do is name your intended beneficiary on a beneficiary form submitted to the custodian of the IRA.
Forgetting to complete or update a beneficiary form is a common mistake associated with planning for IRAs. If you don’t have a form on file, some custodians will default to awarding the account to a surviving spouse, but some will make your estate your default beneficiary. This may result in IRA funds going to people you didn’t intend, or in adverse tax consequences to your heirs.
If you have an IRA, make sure that you have a beneficiary file on form with the custodian, and that the form is updated. For instance, if your spouse is the beneficiary and they predecease you or you divorce them, you will want to amend your form.
Inherited IRAs Aren’t as “Stretchy” as They Used to Be
Not many years ago, if you inherited an IRA, the required minimum distribution (RMD) you would have to take from the account would be based on your remaining expected lifespan, or “stretched” over your lifespan. Many people who inherited IRAs liked that “stretch” feature, because distributions from an IRA are taxable as income. Being able to take smaller distributions over a longer time meant that a distribution was less likely to bump them into a higher tax bracket in any given year.
However, the federal Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 changed that feature of inherited IRAs. Under the SECURE Act, funds in an IRA (including a Roth IRA) inherited by most non-spouse beneficiaries after January 1, 2020 must be withdrawn within ten years. (The rules are more lenient for beneficiaries who are surviving spouses or minor children of the original account owner, and certain others). Furthermore, as most financial advisors told their clients, there was no clear requirement of an annual distribution, so long as all the funds in the account were withdrawn by the end of the ten years.
Unfortunately, the IRS put in place a rule that did require some older beneficiaries of IRAs inherited in 2020 or later to take required minimum distributions, and imposed a very stiff penalty on those who failed to take RMDs in 2021 or 2022. The IRS has since walked back those penalties, saying that they will not apply until 2023, and those who have already paid the excise tax imposed for 2021 or 2022 will receive a refund.
The bottom line on this issue is that the IRS guidance is new and evolving. To avoid paying a penalty of as much as 50% of an RMD you failed to take, consult your estate planning attorney or financial advisor. Similarly, to prevent a tax headache for the beneficiaries of your own IRA after your death, ask your estate planning attorney for help with IRA planning.
Can You Leave an IRA to a Trust?
Many estate planning clients with an IRA wonder if they can make their trust the beneficiary of their IRA. Not only can you make a trust the beneficiary of your IRA, there are a number of advantages to doing so.
Leaving your IRA to a trust allows you to control how much of the IRA assets your beneficiaries can access. A beneficiary must take required minimum distributions, but a person who inherits an IRA outright can take more. If you want to control how much your loved ones receive from the IRA, make your trust the beneficiary; then they will receive distributions according to the terms of the trust.
Making a trust the beneficiary of your IRA is also a good idea if you’re married and have children from a previous relationship. With the trust as the IRA beneficiary, your surviving spouse can receive RMDs during their lifetime, distributed from the trust. When they die, your surviving children can receive the remainder of the IRA assets as the trust distributes them.
Also, if your children are minors, making a trust the beneficiary of your IRA avoids the need to appoint a conservator to manage your children’s assets until they become adults. The IRA assets go into the trust, and are distributed for the children’s benefits according to the trust terms, which you and your attorney established.
Lastly, an asset protection trust can protect inherited IRA assets from your loved one’s creditors. If your family member inherits an IRA outright, their creditors can pursue those funds. If your loved one doesn’t have access to the IRA assets because they are under the control of the trust, the assets may be able to be kept out of the reach of creditors. In order to provide asset protection, a trust must be drafted according to particular requirements. If you are interested in keeping your family member’s inherited IRA out of the hands of creditors, be sure to work with an estate planning attorney who is experienced with these types of trusts.
If you are interested in learning more about how to leave an IRA your heirs, or in how to leave an IRA to a trust, contact Gudorf Law Group to schedule a consultation.