Every client with an IRA or other retirement account must have a designated beneficiary, or bad things can happen. Among them: stretch IRA being lost; children getting disinherited; or the wrong beneficiaries, like ex-spouses, receiving the funds and other unintended consequences.
A designated beneficiary is an individual who is named on the IRA beneficiary form, not in the will. A designated beneficiary can only be an individual: a person, not an entity like your estate.
If the same beneficiary inherits through the will, under the tax law, it is treated as if the estate were the beneficiary. And since the estate is not an individual and has no life expectancy, the inherited IRA must be paid out much sooner to beneficiaries, causing an increased tax bill and diminishing the value of the inherited IRA tax shelter, since it won’t be able to last as long.
A non-person inheriting an IRA, such as an estate, a trust or a charity, cannot use a life expectancy to stretch post-death distributions, because these entities do not have a life expectancy. Only a designated beneficiary can use the stretch IRA to extend distributions over their life expectancy.
If there is no designated beneficiary, the beneficiary who does inherit (possibly through the estate) will have to take the IRA funds out much sooner after death. They will follow the distribution rules that apply when there is no designated beneficiary. Those rules depend on when the IRA owner dies.
If the IRA owner does not have a designated beneficiary and dies before his required beginning date, which is April 1st of the year following the year he turns 70 ½, then the entire inherited IRA must be withdrawn under the 5-year rule. The IRA balance must be emptied by the end of the 5th year after the year of death. That could cause a big tax in a short amount of time if the account is large enough.
It’s even worse with a Roth IRA. If you die without a designated beneficiary on a Roth IRA, the 5-year rule always applies to beneficiaries who end up receiving the Roth IRA through the will or estate.
If death occurs after the age 70 ½ required beginning date and there is no designated beneficiary, then beneficiaries may do a bit better, but not much.
In that case, beneficiaries still cannot stretch distributions over their lifetimes because they were not named on the IRA beneficiary form.
They will be stuck taking distributions over the deceased IRA owner’s remaining life, had he lived. The longest payout possible would be only 15 years. That’s nothing compared to a 30-year old beneficiary being able to extend distributions over 50 years.
A Roth IRA has no lifetime distributions; so regardless of your age, when you die with a Roth IRA, you do so before the required beginning date; and beneficiaries will always be stuck with the 5-year rule if they are not designated beneficiaries.
Remember that these harsher rules only apply when a client dies without a designated beneficiary, like when an IRA is left to the estate. That should not happen.
If you neglect to name beneficiaries, beneficiaries may have a chance to upgrade their status to a designated beneficiary based on who the default beneficiaries are.