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, although some custodians accept designations electronically on a website.  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 owner of a traditional IRA 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, which is calculated based on the owner’s remaining life expectancy.  The initial RMD is small (in percentage), but the distributions will increase in size as the owner gets older.  After the account owner’s death, a named beneficiary will have several payout options depending on the type of IRA and attained age of the account owner.  The inherited IRA custodian will likely permit the beneficiary to take RMDs over the beneficiary’s life expectancy rather than taking a lump sum distribution.  This is generally a good result because it allows for continued income tax deferral inside the account.  
4.  What is the best payout option for a surviving spouse beneficiary?  

From a pure tax-savings 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 and the account owner had already attained age 70.5 prior to death, the individual beneficiary has three basic choices for how to receive the IRA assets:

  • Lump sum distribution (aka "Blow-out")
  • RMDs based on account owner's remaining life expectancy (aka "Ghost Life Expectancy")
  • RMDs based on beneficiary's life expectancy (aka “Stretch-out")

If the account owner died before attaining the required beginning date (age 70.5), the Ghost Life Expectancy option is replaced by a different option called the Five Year Rule.  Under this rule, annual distributions are not required.  The only requirement is that the entire IRA must be distributed by December 31 of the year that contains the fifth anniversary of the account owner's death. 

Accordingly, since Roth IRAs do not have a required beginning date for RMDs during the account owner's lifetime, a Roth IRA beneficiary may choose the Five Year Rule, but not Ghost Life Expectancy.

The Stretch-out option means that the beneficiary must withdraw the RMD each year until the beneficiary dies or the IRA is depleted.  The younger the beneficiary is, the smaller the RMD will be.  Meanwhile the remaining IRA assets continue to be invested in a tax-deferred environment. 

The Blow-out option means that the beneficiary's entire share will be treated as taxable income if coming from a traditional IRA. The after-tax balance will be owned outright by the beneficiary.  Future investment income is also taxable each year because the IRA no longer exists.

6.  May a trust be named as IRA beneficiary?
Yes, there are two primary reasons an account owner might do this.  First, the account owner may want to compel long term income tax deferral ("Stretch-out") rather than assuming the beneficiary will elect it.  Second, a trust may include powerful asset protection features, which may be appropriate when the intended beneficiary is a minor child, or receiving government needs-based benefits, or shows evidence of being a spendthrift, or is involved in ongoing litigation, or is in a fragile marriage, or is recovering from a bankruptcy, or works in a high risk profession for getting sued. 

Another example is when the account owner wants to redirect remaining balance at surviving spouse's death to account owner's children from a prior marriage, rather than spouse's children or new spouse due to remarriage.  

The IRA Protection Trust has become an integral component of comprehensive estate planning.  It formalizes the availability of the income tax-savings "Stretch-out" rules and permits extensive post-death contingency planning and asset protection planning.  

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 after death:
A Closer Look at IRA Protection Trusts (14 page PDF)
Note: Q&A #7 of this article takes a more in-depth look into what typically happens to an IRA after the account owner's death.

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