Retirement Planning Fall 2022

Federal law requires you to designate your spouse as the beneficiary for your 401(k) unless your spouse has signed a written waiver. Unlike a 401(k) plan, you aren’t required to name your spouse as the beneficiary of your IRA (unless you live in a community property state, see IRS Publication 555 here for a list of those states). In addition, your IRA custodian may also require you obtain a spousal waiver consent if your spouse is not your primary beneficiary.

Regardless of the law, spouses are most often named as the IRA beneficiary. And for good reason. It is best to name your spouse as your primary beneficiary because this will stretch out the payment of taxes over the lifetime of your spouse. Otherwise, the entire account would normally have to be paid out over five years.
In addition, only a spouse beneficiary can assume ownership of the IRA and retain the same rights and privileges of the original owner. All other beneficiaries will trigger some form of distribution. Some of these automatic distributions will generate more taxes in a shorter time frame than others.

Does your spouse already have adequate financial resources without including your IRA?
There may be circumstances when it makes sense to bypass your spouse and name another beneficiary. Choosing this course does have some consequences, but it’s possible to have the best of both worlds.
If the spouse has enough other resources and does not need the money in the retirement plan, it might make sense to name the children as primary beneficiaries. When a child inherits money from a retirement plan, he or she can roll it into an inherited IRA. These inherited IRA accounts require a distribution to be made each year to satisfy IRS ‘required minimum distribution’ rules, referred to as ‘RMD.’ The owner of an inherited IRA is required to take an RMD each year no matter what age – not at age 72 as with a traditional IRA that you did not inherit.

You needn’t omit your spouse’s name from the beneficiary list, though. The spouse can still be named as the primary beneficiary, with the children listed as contingent beneficiaries. This offers the advantage of delaying the bypass decision until the spouse stands to inherit the IRA. At that time, if the spouse feels it’s better for the kids to inherit it, the spouse can “disclaim” the IRA. (This must be done in writing.) The IRA would then go to the contingent beneficiaries (e.g., the kids).

Do you have more than one child?

Things can get a little tricky if you have more than one child—whether you list them as primary beneficiaries or as contingent beneficiaries. If you set up the beneficiary designations incorrectly and one of your children predeceases you, you may inadvertently disinherit that child’s heirs.
How does this occur? In a standard beneficiary designation, if the beneficiary passes away before you, all the IRA assets will go to the surviving beneficiaries. That makes sense if the deceased beneficiary had no heirs. But if the deceased beneficiary does have heirs, those heirs would be left out.

By the way, this same problem occurs when there’s only one beneficiary designated. If that beneficiary predeceases the owner of the IRA, when that owner dies the IRA is treated as if there was no beneficiary. The IRA would thus go directly into the estate, generating what may amount to a hefty tax bill.
The solution to this dilemma is to name beneficiaries per stirpes. Such a designation allows deceased beneficiaries’ shares to be passed down to their heirs.

Would you prefer to skip your children and pass your IRA directly to your grandchildren?

If your children are older, they may be in a higher tax bracket. Inheriting your IRA may push them into an even higher tax bracket. In this case, it might make sense to list your grandchildren as the beneficiaries to your IRA. This has the dual advantage of stretching out the lifetime of the IRA even further as well as sending those taxable RMDs to folks subject to a lower tax rate.
Of course, if your grandkids are minors, this may complicate things. It’s not an insurmountable obstacle. You’ll just need to make sure the paperwork is set up correctly (usually by having the parents act as “custodian” of the assets).

Do you want to minimize taxes?

All of the above options represent the best way to minimize taxes incurred by the family over the long run. If you’re interested to learn more on the tax implications of choosing an IRA beneficiary, read what the IRS says about “Required Minimum Distributions for IRA Beneficiaries.”

What if, on the other hand, there’s something more important to you than minimizing taxes? That’s the subject of our final question.

Do you want more control over the timing and exact path of the distribution?
Despite your diligence in your beneficiary naming strategy, bad things can still happen. It’s easy to imagine a series of unfortunate events causing your IRA money to end up in the wrong hands. The best way to avoid this is to have a trust inherit the IRA. Of course, this comes at a cost. Naming a trust is not usually a good strategy because it causes the taxes to be paid sooner on the IRA account. However, when distribution considerations trump taxes, a trust is the best way to protect the funds.

There are a variety of trusts you can use for this purpose. It’s beyond the scope of this article to discuss each of these options. In nearly all cases, though, they give IRA owners the opportunity to continue to exercise dominion of those assets beyond their mortal time on Earth. It really comes down to weighing the costs and benefits to determine if a trust is best for you.

The advantage of a trust is the ability to control the timing of when a beneficiary would get the money. The disadvantage of naming a trust as the primary beneficiary is that tax deferral could be for a shorter period of time than naming a beneficiary directly. That means the possibility of paying more taxes sooner if a trust is the beneficiary.

These seven questions offer you a general guide. Reflect on them as you choose the direction you might wish to take. AFTER YOU’VE GIVEN IT SOME THOUGHT, HEAD ON OVER TO YOUR FAVORITE ESTATE PLANNING ATTORNEY AND GET A REAL LEGAL OPINION ON YOUR SPECIFIC SET OF CIRCUMSTANCES.