Leave an IRA That's Heir-Tight

EDITOR'S NOTE: This article, originally published in the December 2008 issue of Kiplinger's Retirement Report, has been updated in December 2011.To subscribe, click here.The turbulent stock market may have taken a toll on your IRA. Still, there's a good chance that your retirement account holds the lion's share of your savings.

You probably want your assets in the tax-deferred account to last long after you die. If your children or other heirs take required minimum distributions based on their life expectancies, perhaps they can stretch the money well into retirement. Maybe even your grandkids could benefit.

But a slip-up could unravel your fine intentions. You could end up leaving your IRA assets to your Uncle Louie, while your spouse and kids are left out in the cold. Or your IRA custodian could blow the stretch opportunity for your children by liquidating the account after your death.

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With adequate planning, you can avoid mistakes that could jeopardize the legacy you want to leave. IRA rules are complex, so consult with an estate-planning lawyer.

The first step is to designate a beneficiary, or several beneficiaries, on the IRA forms. Make sure you and your lawyer keep copies of the documents. "People think that if they set up a beneficiary, the banks will have it on file," says Ed Slott, author of Your Complete Retirement Planning Road Map (Ballantine, $26). "With all these bailouts and market problems, odds are your beneficiary paperwork is not their top priority."

Also, update your designation forms after major life events, such as deaths, births and marriages. "You want to be sure that the people you want to inherit these assets ultimately receive them," says Jeremy Welther, a certified financial planner with Brinton Eaton Wealth Advisors, in Madison, N.J.

Catherine Schmidt, an estate-planning lawyer with Patterson Belknap Webb & Tyler, in New York City, says an account holder should reconsider designations if the IRA has grown dramatically over time. Say someone planned years ago to leave most assets to her children from her first marriage, with some money going to her current husband. Back then, her IRA made up 20% of her total assets, so she named her spouse as the beneficiary, leaving the other 80% to her kids.

"But after a number of years, the IRA could make up 50% of total assets," Schmidt says. The account holder could then decide to leave a portion of the IRA to the husband and a portion to the kids.

Such a review is particularly important in light of the current economic crisis when your portfolio has likely lost money. Say you specified that $200,000 of your $1 million IRA should go to charity, with the balance going to your child. If your IRA drops in value to $700,000, the charity would still get the promised $200,000, but your child's share would fall to $500,000.

Make sure to also name contingent beneficiaries, who will inherit the IRA if the primary beneficiary dies before the IRA owner. For example, if you named your wife as the primary beneficiary and your daughter as the contingent beneficiary, your daughter will inherit the assets if you and your wife die.

If you name several beneficiaries, you'll need to decide what happens to each beneficiary's share if one dies before you. Say your son and daughter are equal-share beneficiaries. The son has children, and he dies before you. His share could end up going to your daughter, rather than to your son's kids, unless you instruct a per stirpes, or line of descent, distribution.

What if you don't designate a beneficiary on the IRA forms, or what if you name your estate as your beneficiary? The account will likely go through probate, a process aimed at determining the heirs of an estate. Most important, by failing to designate a person on the IRA documents, your heirs can't take distributions based on their life expectancies.

In that situation, how fast heirs must take distributions depends on whether you've begun taking required minimum distributions. If you die before 70 1/2, your heirs must withdraw all of the money within five years after you die. If you die after age 70 1/2, your heirs must take payouts based on your remaining life expectancy, not their longer ones (visit www.irs.gov for life-expectancy tables).

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Account holders with multiple beneficiaries could do their heirs a favor by splitting the IRA into separate accounts for each heir. If several beneficiaries inherit a single account, each one must take distributions based on the life expectancy of the oldest one.

Say you leave your $1 million IRA in equal shares to your sister and three daughters. When you die, your sister is 80 and your children are 40, 35 and 30. All of the money must be withdrawn within 10.2 years -- your sister's life expectancy at the time.

If the youngest child is able to take minimum distributions over her 53.3-year life expectancy, she could withdraw $2.4 million before taxes over her lifetime. By withdrawing over her aunt's life expectancy, she could only withdraw $350,000 before taxes, according to an analysis by T. Rowe Price.

Consider splitting your IRA if you're leaving part of it to a charity. If you don't, your heirs must see that the charity receives its share by September 30 in the year after you die. Otherwise, your other beneficiaries must withdraw all of the assets within five years if you die before age 70 1/2 and over your remaining life expectancy if you die after 70 1/2.

Leaving at least part of your IRA to a charity could be a good tax move for your heirs, if you have other assets to pass down to them. A tax-exempt charity does not pay taxes on gifts, whether the gifts come from an IRA or a taxable account. Meanwhile, heirs must pay ordinary income tax when they withdraw money from an IRA. But they generally don't pay income tax on an inherited taxable account.

Your non-spouse heirs may have to pay estate tax on the IRA. If you don't want them to withdraw from the account to pay Uncle Sam, consider buying life insurance to cover the tax bill. "The death benefit could offset the estate tax," says Welther.

Talk With Your Heirs Now

Your best-laid plans can go awry if your heirs make the wrong moves after you're gone. Be sure to warn them not to allow the custodian to close the account and cut them a check. And non-spousal heirs can't roll your IRA into their own accounts. Either event will wipe out the IRA, and your heirs will pay income tax on the distribution, which may also bump them into a higher tax bracket.

Advise your non-spousal heirs to have the assets transferred directly from the original account to an "inherited" account. The IRA owner's name must be on the new account. For example, if IRA owner Michael Johnson leaves his IRA to his daughter Jessica, the new account would be titled: "Michael Johnson, deceased, for the benefit of Jessica Johnson."

The spouse is the only beneficiary who can roll the money into his or her own IRA. Most spouses benefit from a rollover because they and their beneficiaries can extend distributions over their lifetimes, according to retirement expert Twila Slesnick, author of IRAs, 401(k)s & Other Retirement Plans (Nolo, $35).

For many younger spouses, a rollover usually makes sense. Say an IRA owner dies at 75, and his wife is 65 and doesn't need the money immediately. "By taking his IRA into her own IRA, she doesn't have to take distributions until she's 70 1/2," says Welther. Without a rollover, this wife must start withdrawals a year after her husband dies.

But if the spouse is younger than 59 1/2 and needs to tap the IRA for living expenses, she may want to keep all or part of the money in the deceased spouse's IRA. That way, she can take penalty-free distributions. But if she rolls the account into her own IRA, she would pay a 10% penalty on any distributions.

You could discuss with your spouse the possibility of "disclaiming" -- that is, refusing -- all or part of the IRA if she decides she doesn't need the money. The account will then go to the contingent beneficiaries named by the original owner. A beneficiary must file a disclaimer notice within nine months of the benefactor's death.

There's a potential estate-tax benefit to disclaiming. Say a couple has a combined estate of $11 million, including $5 million in a husband's IRA. When the husband dies, assuming he leaves his entire estate to his wife, she does not have to pay any federal estate tax because of the unlimited marital deduction. If she then disclaims her husband's $5 million IRA, it will not count against her $5 million estate-tax exemption in 2011.

"The wife could disclaim the IRA, and then that money would pass estate-tax-free to the kids," says Lawrence Richman, who chairs the Wealth Services Practice Group at the law firm of Neal Gerber & Eisenberg, in Chicago. And the kids could take distributions based on their own life expectancies. "At her later death, it would maximize the amount of money passing tax-free," he says.

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