If you've taken advantage of opening an individual retirement account (IRA) to prepare for the time you will retire, you need to understand how they work, even after your death. What if you don’t live long enough to collect your entire benefit?
This isn’t a fun subject to discuss, but it’s important to make sure your wishes are accomplished when you’re no longer around. Plus, you want to ensure the people you care about most are taken care of.
The Importance of Naming a Beneficiary
When you open your IRA, it’s vital that you choose a beneficiary who will receive your benefits if you pass away before all your funds are gone. If you don’t designate a beneficiary, then your will goes into effect to determine the beneficiary and/or it’s considered part of your estate. Sometimes the investment company will allow your spouse to claim your IRA, but not always.
If you don’t have a will, then your closest blood relatives are awarded your money and you have no say in the matter. If you name one person as the beneficiary in your will and someone different on your IRA, the IRA takes precedence.
Unmarried partners and friends generally aren’t eligible to receive IRA benefits unless they are officially named as a beneficiary. Choose a beneficiary and update or change your beneficiary as needed (in the case of divorce, beneficiary death, etc.).
Your Spouse Inherits Your IRA
Typically, people name their spouses as their beneficiaries. Children and other family members can also be designated as a beneficiary. And depending on the surviving spouse’s age and whether or not the deceased spouse had begun receiving the required minimum distributions (RMDs), they will have several options that are not available to non-spousal beneficiaries.
The IRS allows a spouse to become the account owner so they can operate it as they please, including making deposits into the account, as well as withdrawals, when they reach age 59.5. Then, this inherited asset is handled just like other non-inherited ones that they own.
A spouse can roll over their deceased spouse’s IRA into their own retirement account or into their employer’s plan. The benefit of rolling over their deceased spouse’s IRA is that they won’t be required to begin receiving distributions right away. The disadvantage of rolling an IRA over is if they are under age 59.5 but their deceased spouse was over 59.5 years old, then they will have to pay a 10% early distribution penalty. If they just leave it alone and put it in their own name, then no penalty is incurred. When they reach 59.5, they can reconsider rolling over their spouse’s IRA.
Other Options for Beneficiaries
Beneficiaries can maintain the IRA they inherit. Inheritors will want to consider this if the deceased was already receiving distributions from the IRA because even if beneficiaries are less than 59.5 years old, they can receive funds penalty free. The RMDs are figured on the deceased’s age, not the beneficiary’s age. Note that taxes may be required.
To avoid large tax payments, beneficiaries can choose to begin receiving regular distributions annually. This is called the stretch IRA because they’re stretching out the payments over a longer period of time and avoiding higher tax brackets. This is particularly beneficial if a beneficiary is young.
Beneficiaries can also convert their inherited IRA into a Roth IRA. If a beneficiary thinks he or she will be in a higher tax bracket when they near retirement, this could be a great option. The downside is they’ll have to pay taxes up front. The upside is they will be free from having to pay taxes or taking required minimum distributions later on.
Beneficiaries also have the option of giving up any claim to the inherited IRA funds. If this happens, the other individuals designated on the IRA beneficiaries’ form would receive the funds.
If a non-spouse attempts to convert an inherited IRA into his or her own name, they can expect large tax fines. But if the deceased was over age 70.5, then they must receive the RMD according to their current age as it corresponds to the IRS life expectancy calculator.
Finally, beneficiaries can cash in the IRA if the deceased owner was under age 70.5. The five-year rule allows beneficiaries to wait until December 31 five years after the death of the owner to withdraw funds tax free. Beneficiaries should also realize that this could put them in a higher tax bracket that year, which means more money goes to the government and less stays in their pockets.
If they cash in an inherited IRA, a 10% early withdrawal penalty will be charged if they are less than 59.5 years old. If it’s a traditional IRA, they can expect to pay taxes on the income.
Making the Right Choices
When you’re handling an inherited IRA, be sure that the financial company responsible for the account registers it under the new name or ownership of the spouse or other beneficiaries.
One thing is for sure: If you’ve experienced the death of a loved one, your head is often spinning and you’re experiencing grief and trauma. It’s not the time to make financial decisions on your own, and often the guidelines and rules around inherited IRAs can be fairly complicated. Consulting with an objective financial advisor who can logically walk you through your options is critical to making the right decisions for your future.
Remember, your IRA doesn't exist just to help take care of you when you retire. It’s also to help take care of your loved ones after you’re gone. You’re working hard to earn your money, so make sure you protect it too, by understanding your options and making the proper arrangements not only for yourself but also for those you love most.
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Disclosure: This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.