Legacy Planning Guide for IRA Holders and Their Beneficiaries

[Updated November 2021]

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Ten thousand baby boomers turn age 65 every day. While not all of them will retire in the traditional sense, it’s fair to say that they are thinking about how to use their retirement savings in the near future and especially in term of legacy planning.

Legacy planning is the process of defining how wealth will be transferred from one generation to the next. This includes how the transfer of your retirement accounts to your beneficiary or beneficiaries will be handled. Some of the questions in legacy planning relate to the timing and the varying levels of taxation on the inherited retirement accounts.

Balances in self-directed IRAs have historically been high, due in part to the sophisticated nature of self-directed investors and their choice of assets. This makes it even more important to be aware of the options available to you and your beneficiary and prepare accordingly. There are two aspects of this preparation: paying attention to the accuracy of the documentation and communicating with the named beneficiaries.

Beneficiary Designation Form

When you open an IRA, you are asked to name your beneficiaries using a beneficiary designation form. The term “beneficiary” is used because your IRA is technically a trust, and that is the term used for people who benefit (inherit) from a trust. You can name one or more individuals or another entity, such as a charity, as your beneficiary.

This document determines who receives your hard-earned savings after your death. You should periodically check to ensure the beneficiary designation form is up to date. Too often, this important document is overlooked, forgotten, and not kept current.

Your IRA custodian will need accurate, current information for each beneficiary, including their:

• Contact information (Email address, telephone number, full address)
• Date of birth
• Tax identification or Social Security number
• Relationship to the IRA account holder

Note: If the beneficiary is a trust, a contact information of the named trustee or a contact from the firm that created the trust. If you name a charity, a contact person from the charity as well as the name, address and TIN of the charity.

If you have more than one beneficiary for your retirement account, you also will need to decide how the benefits will be divided. For example, if you have three beneficiaries, you may leave each one-third of the assets, or half to one beneficiary and one-quarter to the other two. Most beneficiary designation forms allow for different percentages but require that the percentages used are whole percentages.

You also will want to know how the beneficiary designation form a financial institution offers you is designed. The most common design is “per capita.” This Latin term translates to “by head.” It means that, if any primary beneficiary dies before you, their portion of the account will be divided between the other remaining primary beneficiaries. If there are no other primary beneficiaries named, their portion will be awarded to a successor beneficiary, if one has been named or appointed in the plan document by default.

Any number of life events—the death of a beneficiary, divorce, birth or adoption of a child, or a new marriage—may affect your beneficiary instructions. This underscores the importance of regularly reviewing your beneficiary designation form. It is highly recommended to obtain the services of a tax, legal, or estate planner who may be able to make recommendations as part of the services they provide.

Beneficiaries Have Distribution Options

The IRS gives beneficiaries three options for receiving distributions when they inherit a qualified, tax-advantaged retirement account. These options for “inherited accounts” are defined in Internal Revenue Code 401(a)(9). There are typically two options available under the tax code, plus a special rule for spouse beneficiaries.

Fortunately for the beneficiaries, inherited accounts do not have to be distributed and fully taxed upon the death of the original account holder, which could cause an undue tax burden on the beneficiaries.  

Note however, that the choice each beneficiary makes is irrevocable. Even if the inherited account is moved from one custodian to another, the distribution election remains in force. This means the new custodian must acquire all necessary information from the prior custodian to service the account properly.

With the passage of the Secure Act of 2019, beginning tax year 2020, options for non-exempt beneficiaries have been limited to one option for IRA holders deaths starting tax year 2020. This means that depending on when the IRA holder passed away, a different set of options are available to a beneficiary.

Options For Deaths Prior to Tax Year 2020

Five-Year Rule

This option is available if the IRA account holder had not started taking required minimum distributions (RMD) when they passed away. This means that the date of death must have been before April 1 of the year following the date that the account holder turned 70 ½.  The beneficiary may choose to keep the assets in the account, where they continue to grow tax-deferred, for five years.

On the fifth anniversary of the original account holder’s death, the beneficiary must take the entire contents of the account as a distribution.  Any amount that remains in the inherited account will incur a 50% penalty. This is called an excess accumulation penalty and must be paid out of pocket by the beneficiary. The irrevocable election to choose this option must be made by December 31^st of the year following the year of death.

Life Expectancy Payments

This option allows beneficiaries to deplete the inherited account incrementally using the life expectancy of the beneficiary. The IRS uses a standardized life expectancy table, found in IRS publication 590B, to determine the beneficiary’s life expectancy for purposes of calculating how much of the inherited account’s assets must be distributed annually.

The first life expectancy payment must be taken at the end of the year following the death of the IRA holder.  This option is the default option if the beneficiary fails to make an election by December 31^st of the year following the year of death of the IRA holder.

A special rule applies for this option if the account holder passes away after he or she has already started taking RMDs and the beneficiary is older than the deceased account holder. In this situation, the beneficiary may use the deceased’s single life expectancy instead of their own age to calculate the life expectancy distribution.

Like the five-year rule, if a life expectancy payment is not distributed, any amount that is not distributed will incur a 50% excessive accumulation penalty. 

Special Rule for Spouse Beneficiaries

When the beneficiary is a spouse, he or she may choose to keep the assets in the original account (now renamed an inherited account) or to move the assets to their own IRA. This can be done at any time and has no deadline.

One of the reasons a spouse may choose not to treat the assets as their own primarily relates to the 10% penalty on distribution by individuals who are under age 59 ½.

Consider two examples: If a 40-year-old spouse beneficiary decides to take a distribution from their deceased spouse’s retirement account, it will be considered a ”distribution due to death” and exempt from the 10% penalty. However, if a 40-year-old spouse beneficiary decides to move the assets to their own IRA and then takes a distribution from that account, the distribution will be subject to the 10% penalty because it is no longer a distribution due to death.

Multiple beneficiaries

As mentioned above, you may name more than one beneficiary. In this situation, the regulations specify that the oldest beneficiary’s life expectancy will be used to calculate the distributions for all beneficiaries. 

However, the situation changes when beneficiaries’ inherited accounts are separately accounted for by the end of the year following the year of death. Separate accounting means that the beneficiaries’ proportionate shares have been separated by the custodian into individual accounts. In this instance, each beneficiary’s life expectancy can be used for their own inherited account, as if they had been named independent of each other.

If a trust is named as a beneficiary, the age of the oldest beneficiary of the trust may be used to calculate life expectancy payments. A copy of the trust document or certification of the trust must be provided to the custodian no later than October 31 of the year following the year of death. In addition, the trust must satisfy all the qualified trust criteria:  

• Be valid under state law
• Be irrevocable upon the death of the trustor
• Have identifiable beneficiaries

For tax purposes, although the oldest beneficiary’s age is being used to calculate the amount of the life expectancy payment, the tax reporting of the distribution will still be paid to the trust using the trust’s tax identification number. It is the responsibility of the trustee to allocate what the trust receives to the named beneficiaries.

Options For Deaths After 2019

Non-Exempt Beneficiaries

With the passage of the SECURE Act of 2019, beneficiary options for deaths that occur after 2019 will change.

Non-exempt beneficiaries are only left with the new 10-year rule option. Non-exempt beneficiaries are non-spouse beneficiaries who are greater than 10 years younger than the IRA holder’s age. The 10-year rule operates like the five-year rule option, but in this instance, it is extended to 10 years.  Non-exempt beneficiaries do not have the option of depleting their inherited account using their life expectancy. 

After the SECURE Act took effect, many beneficiaries were confused about whether life expectancy payments needed to continue during the 10-year period. In July 2023, the IRS published Notice 2023-54, clarifying the mandate. The notice confirms that non-eligible designated beneficiaries of IRA holders who died after their Required Beginning Date in 2019 must take life expectancy payments and empty the account within the 10-year period.

If you missed an RMD in 2020, 2021, or 2022 due to this confusion, you will not be penalized. However, you will be penalized if you did not take the deceased IRA holder’s RMD in the year of their death.

Exempt Beneficiaries

Exempt beneficiaries on the other hand maintain the life expectancy option to deplete their inherited account. Exempt beneficiaries include the following:

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

Renaming Accounts for Tax Reporting Purposes

The Treasury Department has specific rules about how the inherited accounts should be titled to distinguish the original account from the inherited account. The account name should include the name of the deceased owner and a clear indication that the new individual is a beneficiary. For example: “John Doe deceased FBO Jane Doe.” (FBO meaning “for the benefit of”)

Because the taxation of distributions is passed on to the new owner, the beneficiary’s social security number or tax identification number must be provided to the custodian for proper reporting. The custodian will use this information to report distributions on IRS Form 1099-R for tax purposes, with the beneficiary being liable for any tax due on the distribution. 

Fees

To maintain the tax-deferred status of an Inherited IRA, the recordkeeping fees must be paid to the custodian in a timely manner to avoid a distribution from taking place. As with the original IRA holder, administrative fees can be paid to the custodian from IRA assets or out of pocket by the beneficiary.

Common Mistakes

Whether you are an account holder doing legacy planning or someone named as a beneficiary, you will want to pay close attention to these issues:

• Rolling over or transferring account balances in Inherited IRAs:
   
  • Distributions from inherited accounts of non-spouse beneficiaries or non-individuals cannot be rolled over. They can only be transferred to another inherited account of the same deceased IRA holder.
  • The assets in an inherited account, can ONLY be transferred to the beneficiary’s own IRA when the beneficiary is a spouse.
  • Spouse beneficiaries who choose to treat Inherited IRA assets of their deceased spouse’s IRA as their own, meaning moved the inherited asset to their own IRA, cannot move those assets back to an inherited account.

• Beneficiaries are often unaware that they have been named as a beneficiary in someone’s account. Be sure to inform your beneficiaries that they have been named as beneficiaries. If you were to pass away without having given the IRA custodian enough information to contact your beneficiary, there may be undue tax consequences. Worse yet, if the account falls under the abandoned account definition of state escheatment laws, it may have to be turned over to the state based on the state’s escheatment regulations and process.

• Naming a trust beneficiary may be necessary to carry out wishes that you want to see transpire after death. In some cases, it may be unnecessary to name a trust as a beneficiary since the IRA is a valid trust under state law. Naming a trust beneficiary may eliminate certain options such as the life expectancy option if the trust is not designed properly.

• Required minimum distributions must still be distributed, even in the year in which the original account holder died.

In Conclusion

As you can see there are many issues that an IRA account holder needs to plan for and resolve to ensure that assets get to the rightful beneficiaries. And the beneficiaries will have to be vigilant about how they manage the assets to preserve their tax-advantaged status, or at the very least, minimize any tax consequences.

It is good to start early and communicate with beneficiaries. This allows you to update the information you provide to your IRA custodian and to educate your beneficiaries on their options as well as steps to take so they can make informed decisions.

Feel free to reach out to us at 800-392-9653, option 2, or fill up our free consultation form here so we can answer any questions you have.