Why Beneficiary Designations are Important
At the end of 2019 we were all a bit surprised by the details of the SECURE Act, which, among other things, changed the way distributions from (and therefore income taxes on) inherited IRAs from decedents who died on or after 1/1/2020 worked. If you haven’t considered your beneficiary designations in a while, you should.
It’s great that you’ve saved in your retirement account, but for tax planning, both before and after your death, it is important to think of dollars in tax advantaged (such as non-Roth retirement) accounts as having a ball and chain attached to them – that is, they still carry with them the burden of income tax. Either you need to pay that income tax, or your beneficiary does, whenever those dollars are distributed out of the account and to the recipient. Therefore, it is important to have thought through the consequences of who you have designated – and what that means in terms of how the funds can be distributed to them, and when income tax on those funds will therefore become due.
Ideally, you want the beneficiary who inherits your account to have as many years as possible to take distributions from it, rather than being pressed into taking distributions out over a shorter number of years. This “stretching” of distributions allows for them to take (potentially) less from the account each year, thereby limiting the amount taxed at higher tax brackets, and also allows for your beneficiaries to take into account other factors impacting their taxes each year, such as an upcoming retirement or a year with higher-than-average deductions.
If you don’t name a beneficiary, or name only deceased beneficiaries, you can get the worst possible tax outcome, with the account paying to your estate. In that case, if you die before the “required beginning date” of when you would take your own required minimum distributions (RMDs), the longest the distributions can stretch after your death is 5 years, which is very limiting. If your account passes to your estate and you die after your required beginning date, the distributions after your death can instead be taken over what your life expectancy would have been had you not died (a strange concept, for sure). An additional problem with distributions to estates, though, is that for even these estate distributions to work, in most cases your estate will have to remain open for all of the years of distributions, which itself is an administrative burden for your personal representative (Executor or Administrator). Additionally, to make sure that the distributions are not taxed at the typically higher tax rates estates are subject to, careful tax planning will have to be an ongoing task.
If you name your spouse, or certain other “eligible” beneficiaries, such as disabled or chronically ill beneficiaries (or certain Trusts for their benefit), those beneficiaries can stretch distributions over their lifetimes (using either the IRS’s Single Life or Uniform Life tables to calculate those RMDs, depending on the situation).
If you name your own minor child (minor children of other people, including your grandchildren, don’t count!), or a specially drafted Trust for their benefit, those beneficiaries can take distributions slowly until then reach age 21, and then the 10 year countdown starts when they turn 21.
If you name any other individuals, either outright or in most Trusts, those beneficiaries can stretch distributions over 10 years, starting the year after you die - often with age-dependent RMDs required for the first 9 years, but a requirement that the account be empty by the end of the 10th year.
If you already are planning on a charitable gift upon your death, then funding that gift through naming the charity as beneficiary of your retirement account (or as a partial beneficiary), can have major benefits – both for income taxes and estate administration. Please see our separate blog post that dives into this option a bit more.
In all cases, the RMD that you should have taken in the year of your death is still what controls for that calendar year. Again, because of the income tax considerations of retirement accounts, it is important to consider the relevant distribution periods when naming beneficiaries. Will this change your overall estate plan? Likely not – but it might change the way you allocate different accounts among beneficiaries, might mean that you “gross up” the gifts passing to beneficiaries who will have an income tax burden associated with their inheritance, or might mean that the terms of a Trust that will be named as beneficiary are carefully considered, so that the longest possible distribution remains available. When you name individuals as beneficiaries, you should additionally consider naming them on a “per stirpes” basis. Please see our separate blog post on what this term means, and how it is used in beneficiary designations.