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How to Leave a Legacy With Your Retirement Plan

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[Updated November 2021]

Estimated reading time: 4 minutes

Many people wonder if they have enough in their retirement savings plans to sustain themselves during retirement. On the other hand, some people have more than enough.

Beneficiaries of these retirement plan accounts need to be aware of their options and election deadlines to avoid penalties and unintended tax consequences.

When a retirement plan participant or IRA holder passes away, the beneficiaries have certain options to postpone taxation on amounts they have inherited. Treasury Regulation 1.401(a)(9) outlines the rules for beneficiary options on retirement plans. Beneficiary distributions are considered Required Minimum Distributions (RMDs). Failure to distribute these required distributions may subject the beneficiary to a penalty of 50% of the amount required to be distributed.

Knowledge of the options will not only help avoid the penalty but may also help defer taxation by choosing certain options.

After a retirement participant or IRA holder dies, the beneficiary is given until December 31st of the following year to choose the option on how they would deplete the account they just inherited. The election they make is irrevocable. There are typically two options available for the beneficiary; the five year rule or life expectancy payments.

The Five-Year Rule

This option is only available if the IRA holder dies before the time they are subject to RMDs.  This means that the beneficiary does not have to take a total distribution until the year that contains the fifth anniversary of the IRA holder’s death. If the balance on the IRA is not completely distributed on the deadline, whatever remains in the IRA will be subject to a 50% penalty. For IRA holder deaths that occur after tax year 2019, this option will only be available to non-individual beneficiaries such as charitable institutions.

The Ten-Year Rule

This new option only applies to non-exempt beneficiaries of deaths that occur after tax year 2019.  Nonexempt beneficiaries include non-spouse beneficiaries who are greater than 10 years younger than the IRA holders age.  This is the only option for non-exempt beneficiaries, regardless of how old the IRA holder was when they died.

Life Expectancy Payments

This option typically requires a small distribution starting December 31st of the year following the year of death. The distribution is based on the life expectancy of the beneficiary which could prolong the tax deferment of the investments for a longer period than the previous option.

Another term typically used by the retirement industry is the “stretch option.” If the beneficiary fails to make an election, the regulations require the default elected option to be the life expectancy one.

Under the rules prior to 2020, any non-spouse beneficiary and spouse beneficiary can elect to deplete their inherited account using their life expectancy or the oldest beneficiary if there are multiple beneficiaries.  Starting in 2020, however, only exempt beneficiaries can use the life-expectancy option.  Exempt beneficiaries include the following:

  • Spouse
  • Non-spouse less than ten years younger
  • A chronically ill or disabled beneficiary
  • A minor who has not reached age of majority – will revert to the 10 year rule once the minor reaches age of majority

How Calculations for Beneficiaries Really Work

Imagine a young beneficiary, age 20, inherits an IRA. The life expectancy of a 20-year-old found in IRS Publication 590B is approximately 63 years under the old life expectancy tables. Thus, the balance in the account inherited may be potentially stretched out for 63 years. The minimum distribution for the initial year is calculated by taking the prior year’s Inherited IRA balance divided by the life expectancy of 63. This incremental distribution could create a stream of payments to the beneficiary essentially for the rest of their life.

Depending on the type of IRA inherited; the distribution may be subject to tax (Traditional) or tax-free (Roth). Beneficiary distributions are never subject to the early distribution penalty of 10%. It's good to note however, that although there are minimums required to avoid the 50% penalty, a beneficiary may always distribute more than what is required.   

If the beneficiary dies and the beneficiary has named a subsequent beneficiary under their inherited account, the new beneficiary will be subject to the 10 year rule option. This gives the new beneficiary 10 years to deplete the account they’ve inherited from the previous beneficiary.

If the beneficiary of the IRA holder is the spouse, the spouse has a special option of treating the IRA as their own. The most common practice to treat the IRA as their own is to have the spouse create their own IRA if they do not have one already established. Once the IRA is established the assets are transferred as a non-taxable transaction from the deceased person's IRA to the spouse beneficiary’s own IRA.

Retirement plans may not only provide retirement income to the retirement plan participant or IRA holder while they are alive, but they can benefit beneficiaries for the long run. If certain elections are made, the tax law also allows for a stream of income for the beneficiary for the rest of their life. Set up a long-lasting legacy with a retirement plan.

Professionals, Take Note...

Professionals like Financial Advisors, banking personnel, brokerage firm representatives, CPAs, CFPs and other professionals need to stay educated to help their clients with questions they may have regarding beneficiaries, and additional pertinent information. IRA Academy provides professionals with educational classes on IRAs and IRA-based employer-sponsored plans.

This event is open to anyone who wants to stay competitive in the retirement field. Register now or click here for more information.

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