Avoiding the IRA Beneficiary Tax Trap

Be careful who inherits your IRA, and be smart about how they are allowed to do it. It could save them a potentially 40% tax hit.

(Image credit: Zelfit)

People often don’t make the time to check their beneficiaries, but if you own any retirement savings accounts, such as an Individual Retirement Account (IRA), 401(k) or other accounts that offer tax-deferred growth, you may be surprised at who might benefit from your account in the event of your passing.

IRAs appeared for the first time on the financial scene in 1974. These accounts were never intended to be assets you could pass on to beneficiaries, but only to encourage retirees to have a secondary source of steady income to supplement their Social Security benefits and employer pensions. For this reason, Required Minimum Distributions (RMDs) were enacted for account owners once they turned 70½, so that they would ideally deplete their resources throughout retirement (and eventually pay taxes on the tax-deferred earnings).

Without proper planning, your IRA could easily become a tax nightmare. However, you can avoid this tax trap by properly planning your beneficiaries, picking the right retirement account type, and making sure to find the proper adviser to help with the process.

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Changes in the new millennium

Beginning in 2002, a few significant changes occurred for IRAs and the policies that govern their distributions. Life expectancy tables were updated to reflect longer life spans, more options if the account owner’s spouse was more than 10 years younger, and the Separate Account Rule was implemented. Essentially, this rule allows account owners to choose how their beneficiaries would receive the remaining funds in their retirement — either in a lump sum (the previous mandatory policy) or allowing the funds to continue earning tax-deferred benefits.

If IRA owners want their beneficiaries to continue enjoying the benefits of tax-deferred earnings, they need to make the right beneficiary choices. Referred to as the “Stretch IRA” or “Multi-Generational IRA,” this will alleviate beneficiaries from immediate taxation on a lump sum or five-year distribution, which can be up to a 40% or more immediate loss of the account balance.

The “Stretch IRA” concept

A Stretch IRA can save your beneficiaries (and potentially, if planned properly, their beneficiaries) thousands of dollars in unforeseen taxes. A Restricted Beneficiary Form can designate the creation of a separate account for each beneficiary in their name. However, your beneficiaries will need to begin their RMDs starting the year after your death, not by age 70½ (the age you would typically start distributing RMDs). They must pay taxes on only the amount withdrawn every year from the retirement accounts, taxed as ordinary income.

Picking your beneficiaries

The process of picking and keeping your beneficiary wishes up-to-date may be a complicated one, but the right financial adviser will help ensure that all the proper steps are in order. Don’t make the mistake of assuming that your survivors will fulfill your intended wishes. Also, another costly mistake is assuming that your will handles retirement account beneficiary designations. For that reason, beneficiary forms always surpass instructions found in your will—thus making them crucial documents to have in your possession.

Things to keep in mind

  • If you have no beneficiaries listed or the designated beneficiaries have passed away without any others listed, the account will end up in probate and be subject to taxation vs. going to a survivor of the original account owner.
  • Depending on the account (employer-sponsored plan vs. IRA or Roth IRA), different rules may come into play. Most company plans, such as 401(k)s, normally transfer account values to the spouse automatically, while IRA rules may vary by state. Updating your beneficiaries in the event of a divorce or marriage is therefore important because most laws favor spouses.
  • Make sure if you name minor children that you’ve appointed a proper guardian who can manage the accounts until the minor becomes an adult.
  • Change beneficiary designations after major events like weddings, divorces, births, deaths or illnesses.
  • Beneficiary designations do not carry over when you transfer or roll over funds to a new custodian or institution.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Carlos Dias Jr., Wealth Adviser
Founder and President, Dias Wealth LLC

Carlos Dias Jr. is a financial adviser, public speaker and president of Dias Wealth LLC, in the Orlando, Florida, area, offering strategic financial planning services to business owners, executives, retirees and professional athletes. Carlos is a nationally syndicated columnist for Kiplinger and has contributed, been featured or quoted in over 100 publications, including Forbes, MarketWatch, Bloomberg, CNBC, The Wall Street Journal, U.S. News & World Report, USA Today and several others. He's also been interviewed on various radio and television stations. Carlos is trilingual, fluent in both Portuguese and Spanish.