What You Should Know About IRA Distributions after Death
1.  What happens to an IRA after its owner’s death?

After the death of its owner, an Individual Retirement Account (“IRA”) will be distributed in accordance with the most recent beneficiary designation on file with the IRA custodian.  If there is no beneficiary designation on file, or if the named beneficiary does not survive the account owner, then the balance of the account will be paid to the IRA owner’s probate estate. 

A beneficiary designation is usually made on a pre-printed document signed by the IRA owner.  The IRA owner’s will is not considered a beneficiary designation. 

2.  Are IRA distributions taxable to the beneficiary? 

The beneficiary of a traditional IRA must pay income tax as the funds are received.  A Roth IRA is funded with after-tax dollars, so the beneficiary inherits the account free of income taxes.

3.  What are Required Minimum Distributions?
A living IRA owner must begin to take distributions from the account during the year that the owner attains age 70 ½ years of age – even if the owner does not want or need to.  The required amount is called the required minimum distribution or RMD for short.  Each subsequent year the tax law requires the owner to take a distribution from the account.  The initial RMD is small (in percentage), but the distributions will increase in size as the owner gets older. 

After the IRA owner’s death, a named beneficiary has the option to continue taking RMDs over the beneficiary’s life expectancy (rather than taking a lump sum payment).  This is generally a good result because it allows for continued income tax deferral inside the account. 
4.  What are the payout options for a surviving spouse beneficiary?  

From an income tax perspective, the best result occurs when there is a surviving spouse.  A surviving spouse can “roll over” the IRA into the spouse’s IRA.  This permits a younger spouse to wait until age 70 ½ before starting to take RMDs.  Also, a surviving spouse calculates RMDs using a different, more favorable, IRS tax table.  A third benefit is that the spouse’s life expectancy is recalculated each year so that RMDs increase at a slower pace than they would for a non-spouse beneficiary.

5.  What are the payout options for a non-spouse beneficiary?  
When a non-spouse individual is named as beneficiary, the individual has two basic choices for how to receive the IRA assets:

  • Lump sum payment
  • RMDs based on life expectancy (“Stretch IRA”)

A third option, called the Five Year Rule, is available when the IRA owner died before reaching age 70 ½.  The only requirement is that the entire IRA must be distributed by December 31 of the year that contains the fifth anniversary of the IRA owner’s death.

The lump sum payout option means that the beneficiary will treat that amount as taxable income and pay income taxes on the entire amount immediately.  The after-tax balance will be owned outright by the beneficiary.  Future investment income will be taxable each year.

The Stretch IRA option means that the beneficiary will receive the RMD each year until the beneficiary dies or the IRA is depleted.  The younger the beneficiary is, the smaller the RMD will be. 

6.  May a trust be named as IRA beneficiary?
Some IRAs name a trust as beneficiary.  There is nothing wrong with this from a legal perspective.  In fact, it may make perfect sense if the owner wants to protect the inheritance of a minor, incapacitated, or otherwise irresponsible beneficiary (or those with creditor or divorce concerns).  However, a trust, in general, does not qualify for the Stretch IRA option because it is not an individual with a life expectancy.  In order to make a trust qualify, the trust must meet specific requirements.  If they are met, then the IRS permits the IRA custodian to identify the beneficiaries by “looking through” the trust.  Unless sub-trusts are identified separately in the beneficiary designation itself, the IRA will pay out RMDs using the life expectancy of the oldest trust beneficiary.  When drafted correctly, it is perfectly acceptable to name a trust as beneficiary.  The document must comply with all the appropriate tax rules, but otherwise there are no restrictions on what it may provide, other than what the IRA custodian will approve.

A growing number of IRAs are made payable to so-called IRA trusts.  These trusts are specifically drafted to deal with retirement plan accounts.  They are intended to insure the availability of Stretch IRA provisions, maximize creditor protection for the beneficiaries, and provide ongoing professional management of the investments. 

About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection.  He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law.  Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.

Learn more about IRAs payable to Trusts:
A Closer Look at IRA Protection Trusts (11 page PDF)

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Thomas J. Bouman, Attorney
Bouman Law Firm
7650 E. Broadway Blvd. #108
Tucson, AZ 85710
(520) 546-3558