A beneficiary is more than just a name. The decisions you make today can affect your future—and the future of those you care about.
It’s important to think about the tax impact of passing on any retirement accounts when choosing a beneficiary.
Distribution rules: When must your beneficiary take required minimum distributions?
Unlike some other inherited assets, retirement accounts can trigger an income tax liability to your beneficiaries when they make a withdrawal from the plan.
Beneficiaries of an inherited retirement account must take annual required minimum distributions depending on whether you reached your required beginning date at your death. If you die before your required beginning date, your plan assets must be distributed within five years of your death unless the benefits are left to a designated beneficiary. A designated beneficiary can withdraw the benefits over the individual’s (or individual trust beneficiary’s) life expectancy.
If you die after your required beginning date, your plan assets must be distributed over your remaining life expectancy (based on IRS tables), or over the designated beneficiary’s life expectancy, whichever is greater.
How can your beneficiary delay taking withdrawals?
Your beneficiary may be able to delay or “stretch out,” taking withdrawals (in turn deferring the income tax) depending on whether:
- You reached your required beginning date for taking lifetime withdrawals at your death
- Your beneficiary qualifies as a designated beneficiary
- Any additional strategies, such as naming a trust as a beneficiary, have been implemented
Distribution options and beneficiary types
The distribution options for an individual beneficiary depend on how you’re related. There are a few beneficiary types to choose from. If your beneficiary is your:
- Spouse: They can roll over the inherited plan into their own Individual Retirement Account (IRA), take distributions based on their own required beginning date and name their own beneficiaries — who can potentially stretch the payout of the retirement account over their life expectancies. Or, your spouse can choose to take immediate distributions over his or her life expectancy.
- Children, grandchildren or another individual: They can establish an inherited IRA to hold the inherited retirement accounts. The beneficiary can then stretch out the withdrawals from the inherited IRA by taking minimum withdrawals over their life expectancy.
Regardless of whom you choose as your beneficiary, make sure they have the support and information they need to make decisions easier as they manage their inherited assets.
Naming a trust as your beneficiary
For some people, it may not make sense to name an individual as the beneficiary. In these cases, certain trusts may be considered a designated beneficiary, allowing the withdrawal of the benefits to be based upon the life expectancy of the individual beneficiaries of the trust. These trusts are sometimes referred to as “look through” trusts. The trust must meet the following IRS requirements to qualify:
- The trust must be valid under state law
- The trust must be irrevocable as of the date of the participant’s death
- Certain documentation must be provided to the plan administrator
- The beneficiaries must be identifiable from the trust instrument and must be individuals (e.g. no charities)
If a trust meets these requirements, then withdrawals can be based on the life expectancy of the oldest trust beneficiary, or potentially on the life expectancy of each individual beneficiary.
Simple or complex?
Even though naming an individual as your beneficiary is the simplest and easiest way, sometimes estate planning goals call for using a trust, despite the added complexity. You can still get favorable income tax results by making sure that the trust is structured properly for this purpose. Your estate planning attorney can help you make these decisions and add the proper provisions to the trust.
Now that you have a better understanding of what is involved in choosing a beneficiary, it may be time to hold that family meeting to help ensure your family’s financial health.