- Every situation is as unique as you are, so don’t shortchange yourself with an off-the-shelf, cookie-cutter solution.
- The beneficiary you designate for your IRA can have a big impact on what happens to your IRA when you pass away.
- Your age can have a big impact on what happens to your IRA.
“What happens to my IRA when I die?”
It seemed a like a fairly straightforward question when our friend and longtime client, Howard, posed it recently. I told Howard it was a great question, and as a reader of our blogs, he suggested that I write about it. Howard’s question occurred during a conversation we had several months ago. While I was able to answer his question during our call, I hesitated to write this blog because of the complexity of the topic. Howard’s specific situation allowed me to zero in on an answer for him much faster than I could write a general post designed to address every possible IRA transfer scenario.
The remainder of this post will be devoted to the most common IRA transfer scenarios, but should not be viewed as a one-size-fits-all solution. Everyone is unique and your planning should always reflect your personal situation.
Most people’s wills do not specify or control what happens to their IRAs. That’s because an IRA has its own distribution schedule that operates independently of a person’s will. IRAs have beneficiary designations that are created when the IRA is opened. These beneficiary designations should be reviewed on a regular basis and can be changed with written notice at any time prior to one’s death. Most people name their spouse as their primary beneficiary and then their children as contingent beneficiaries, with the children splitting their shares equally.
The rest of the answer to Howard’s original question depends on who inherits the IRA. If a spouse inherits the IRA, then the spouse can treat it as her own IRA or treat it as an inherited IRA. There are advantages and disadvantages to each approach. Most people treat their deceased spouse’s IRA as their own and then follow the same distribution schedule as they would for their own IRA.
Children or other non-spouse beneficiaries treat the IRA as an inherited IRA and have the following options:
- Take the IRA as a lump sum. Most people do NOT choose this option because of the adverse tax consequence of taking a large distribution at one time. As an alternative to the lump-sum method, beneficiaries may withdraw the balance of their IRAs over a five-year period, but this method has similar disadvantages to the lump-sum method.
- Use the Life Expectancy Method. Under this method, the beneficiary must receive a certain minimum amount each year. The beneficiary can always take larger distributions than required, but if they withdraw less than required in any year, a 50 percent federal penalty tax will apply to the undistributed required amount. The main advantage of the life expectancy method is that it typically allows distributions to be taken over a period of many years. A longer payout period can provide significant income tax advantages.
At age 70 ½, IRA owners must begin what are known as Required Minimum Distributions or (RMDs). That means they are required by law to start taking a designated portion of money out of their retirement accounts or else suffer penalties. Whether or not an IRA owner has begun required minimum distributions can also have an impact on the calculations for the life expectancy method.
I like this IRA question from Howard for several reasons. First, I’m sure other clients and followers of this blog have wondered the same thing about their own IRAs. Second, a question like Howard’s crosses several different wealth management disciplines– estate planning, retirement planning and tax planning. A well designed wealth plan will consider all of these areas and the client’s individual situation and circumstances. When is the best time to think about these issues? Right now, well before we need the plan to work. Do you have a question like Howard’s? Please let us know and maybe your question can be the topic of our next blog.