Retirement planning involves more than merely ensuring you have enough income in your old age. It's also important to think about what will happen to your retirement assets when you die. If you don't name beneficiaries for your traditional IRA, it will be liquidated and become part of your estate. If a beneficiary is named, he has the choice to keep funds in the inherited IRA and enjoy the same tax-exempt growth you did.
When you die, an IRA shouldn't pass through your will. Instead, it should go directly to a beneficiary, who will decide how to handle the assets. Choosing a beneficiary can be difficult, but don't dodge the decision by naming yourself or not designating a beneficiary. Unless your beneficiary is your spouse, who has more options with an inherited IRA, the heir's projected lifespan will determine how much money must be withdrawn from the IRA each year. This may drastically limit the heir's tax-free gains.
If you name your spouse as the beneficiary to your IRA, he has several options on how to handle the account after your death. He can simply treat it as his own IRA, declaring himself as its owner and making contributions to it. He may also roll it over into his own IRA or other qualified account such as a 401(k) plan. If he chooses to roll the account over, the IRS only gives him a 60-day window to do so. Therefore, it's important to let your spouse know about his options in advance to avoid missing the deadline. A spouse who is named as a beneficiary to your IRA may also exercise options available to nonspouse beneficiaries.
If you name someone other than your spouse as your IRA beneficiary, she has fewer options. She can't treat it as her own IRA, making contributions or rolling it over to an existing account. She must also choose between receiving required minimum distributions or cashing out the account. In either scenario, the beneficiary pays income taxes on the distribution. If your beneficiary chooses to receive RMDs, she estimates her lifespan based on IRS tables and receives distributions based on this. The rest of the money continues to grow tax free.
Some investors fund a "legacy IRA" by naming a child or grandchild as the beneficiary and avoiding distributions as long as possible. When they die, the beneficiary receives the IRA and can receive RMDs. While a traditional IRA can work for this purpose, a Roth IRA is usually suited to a legacy investment. With a Roth, the original account owner doesn't need to begin receiving RMDs at age 70 1/2, as with a traditional IRA. Also, because Roth distributions are tax free, your heirs might receive tax-free income when they begin receiving their RMDs from your IRA.
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.