By Jim Glass, JD
IRAs have beneficiaries and “designated beneficiaries,” and it is important to know the difference. If you wish your heirs to have the opportunity to take full advantage of “stretch” IRAs, and to avoid other possibly costly mistakes, be sure your heirs are designated beneficiaries. Here’s the difference and why it matters.
The beneficiary that inherits an IRA can be an individual or a legal entity such as a charity or an estate. But a designated beneficiary must be a living person ‘with a pulse’ who is named on the beneficiary form of the IRA.
The major advantages of a designated beneficiary are:
- Distributions from inherited IRAs can be stretched over a designated beneficiary’s lifetime, possibly allowing decades of tax-favored investment returns to be earned in the IRA.
- The IRA passes directly to a designated beneficiary, escaping complications like probate.
The Value of a Stretch
Say that Jack Sr. leaves his IRA to his estate, naming it as the IRA beneficiary, and his will instructs that the IRA proceeds be distributed to his grandson Jack III, who is age 22 when Sr. dies.
The estate is not a designated beneficiary. Thus, the tax code says the IRA must be paid out to the estate over a period determined by whether or not Jack Sr. had reached his required beginning date (RBD) for taking annual required minimum distributions (RMDs) when he died.
- If not then the IRA balance must be paid out in five years.
- If so then the IRA can be paid out over his projected life expectancy just before he died, a maximum of about 15 years.
In contrast, if Jack III had been named on the beneficiary form, the IRA could be paid out to him using his own life expectancy of 61 years, until age 83! The future tax-favored payoff could be immense. (See https://www.irahelp.com/slottreport/how-much-can-stretch-ira-be-worth )
To obtain the difference between a 5-to-15 year IRA payout period and one that might run for several decades, name a designated beneficiary.
The Cost of Probate
If an IRA is left to an estate it becomes an asset that must pass through probate, and here other problems may arise:
- Delay. Probate is a legal process that may be time consuming.
- Cost. Probate isn’t free. The cost may be a percentage of the probate assets, in which case running IRA funds through probate will needlessly impose this cost on them.
- Loss of confidentiality. Wills are public documents and probate is a public process.
- Possibility of contest. A disgruntled heir could challenge the will, bringing into question who will get the IRA funds.
- A will may be obsolete – or lost. People are often late about updating their wills, meaning IRA funds may not pass as would be desired. If a will is lost, the situation will be worse. The IRA funds may be distributed under state law in a way plainly contrary to the owner’s intent.
Instead, naming the IRA beneficiary on a beneficiary form avoids all these problems, simply and cheaply. Beneficiary forms can be updated easily, at will.
So even if a beneficiary such as Jack III won’t use a stretch IRA and intends to cash in the IRA immediately, it is still best to name him on the beneficiary form.
When one IRA beneficiary form names multiple beneficiaries, the stretch period of years to be used by them all is the shortest. Thus if Jack Jr., age 45, was also a beneficiary with Jack III, the number of years of stretch for both of them would be 38.8, Jr.’s life expectancy. Jack III would lose about 22 years of potential stretch.
Even worse, charities and estates as non-humans have no life expectancy. Thus, if either one was also named on the form, the human beneficiaries, such as Jack Jr. and Jack III, would not be entitled to a stretch at all.
The solution to this problem is to split the IRA. In the year after the IRA owner dies, non-human entities can be cashed out of the IRA by September 30 , leaving the human beneficiaries as designated beneficiaries. They then can split the IRA into their own separate IRAs by December 30, each taking a stretch based on their own life expectancies.
An IRA can be left to an estate on purpose or by accident, such as when a beneficiary form is lost so the IRA custodian pays the IRA to the estate by default.
Don’t let either happen. Use and update beneficiary forms regularly, to name and protect your designated beneficiaries.