Retirement planning isn’t limited to structuring your finances for the remainder of your life. A careful investor pays attention to what happens to his money after he dies as well. Although, only a handful of investors need to concern themselves with keeping an IRA from passing to their estate, which would then be distributed through probate to heirs, and going directly to heirs who are named as beneficiaries.
In most cases, investors select a primary beneficiary and contingency beneficiaries when they establish their IRAs. If the IRA’s owner dies before the IRA’s funds are depleted, the remaining amount passes directly to the beneficiary, effectively bypassing probate and potential estate taxes. If the owner of an IRA dies without naming a beneficiary to the account – or the beneficiary is dead – the IRA’s balance passes to his estate and is distributed as instructed by his will.
IRAs in Probate
If the deceased’s IRA passes to his estate rather than directly to a beneficiary, the IRA’s custodian liquidates the account, and sends the funds to his estate. If his estate is large enough to qualify for the estate tax – those larger than $5 million, though that amount may be smaller if he used a portion of his unified credit to avoid gift taxes in his lifetime – the IRA’s value is added to the taxable amount and his heirs only receive the portion of its amount that remains after taxation.
Spouse as Beneficiary
If the beneficiary of the IRA is the deceased’s spouse, he has the option to roll over the IRA into his own IRA if he doesn’t wish to immediately access the funds. The Internal Revenue Service treats beneficiary rollovers in a relatively straightforward fashion, and the new funds are treated the same as if they were contributed by the spouse.
All beneficiaries, whether a spouse or another person, may choose to maintain the IRA as a stretch IRA, also known as a legacy IRA. In this scenario, the beneficiary must begin taking minimum required distributions from the IRA, which are calculated based on the amount left in the account and his projected lifespan. These distributions aren’t subject to the 10 percent early distribution penalty if the beneficiary hasn’t reached retirement age, although the IRS treats them as ordinary income, subjecting them to income taxes. To do this, the beneficiary and the deceased most both remain named on the IRA, as if only the beneficiary is named as an owner, it’s treated as taxable income.
Cash Out IRA
The beneficiary can also choose to take the money and run, so to speak, by cashing out the IRA. While beneficiaries aren’t subject to the early distribution penalty if they choose this option, the amount they receive is immediately taxable as income. If the IRA was large enough, this may significantly increase the beneficiary’s tax rate, and increase the taxed portion of the IRA as compared to a stretch IRA option.