July 24, 2023
Death of an IRA Beneficiary
Take-Away: Individuals who inherit IRAs need to promptly name successor beneficiaries to that IRA in order to avoid having their estate deemed the successor beneficiary.
Background: Those who are familiar with the IRA distribution rules (or more likely, continue to struggle to become familiar with those ever-changing rules) know that there can be an extended period of time in which the IRA beneficiary designation is ‘processed’ after the IRA owner’s death before the IRA assets actually move to a new account or into the hands of the beneficiary. The Tax Code provides deadline dates long after the retirement account owner’s death in which to identify the actual designated beneficiaries of the inherited IRA account, like September 30 of the year that follows the retirement account owner’s death, to determine if all the named beneficiaries of the account are designated beneficiaries, i.e. individuals and not entities. There are also several decisions that the designated beneficiary must make with tend to delay actually taking control of the inherited IRA. Consider the many options a surviving spouse must ponder before taking his/her deceased spouse’s IRA. Or the ‘hoops’ some designated beneficiaries may have to ‘jump through’ to prove that they are eligible designated beneficiaries, i.e., clinical proof of chronic illness. Thus, months, if not well over a year, can sometimes pass before the designated beneficiaries are determined and the inherited IRA assets are distributed from the decedent’s IRA. Consequently, there can be a gap in time between when the IRA owner dies and when their IRA assets are actually moved into the designated beneficiary’s inherited IRA account, or rolled over.
Question: This potentially large gap in time between when the IRA owner dies and when the IRA assets are actually moved into the designated beneficiary’s inherited IRA (or rolled over to the surviving spouse’s own IRA) then leads to the question: What happens if the designated beneficiary dies before he/she actually claims the inherited IRA and has the assets moved into his/her own inherited (or rollover) IRA? Who owns those IRA assets?
Answer: What may come as a surprise to many, the assets held in the decedent’s IRA do not pass to the IRA’s contingent beneficiary. So long as the primary designated beneficiary was living on the date of the IRA owner’s death, the named contingent beneficiaries (if any) are pretty much ignored. Unless the primary designated beneficiary disclaims his/her interest in some or all of the decedent’s IRA, the named contingent beneficiaries on the beneficiary designation form become irrelevant. As soon as the IRA owner dies, the primary designated beneficiary is immediately deemed to be the new owner of those IRA assets under the IRA custodial agreement.
Successor Beneficiaries: The designated beneficiary thus needs to as soon as practicable name successor beneficiaries to their inherited IRA.
No Successor Beneficiaries: If the designated beneficiary dies without naming any successor beneficiaries to the inherited IRA, then the inherited IRA will be deemed to be an inherited IRA with no named beneficiary.
Default Beneficiary: If there is no named successor beneficiary to the IRA, then the default beneficiary is determined with reference to the IRA custodial agreement. The default beneficiary is often the deceased account owner’s estate.
Probate Estate: In short, the new account owner’s probate estate is deemed to be the successor beneficiary of the IRA. The decedent’s estate would be bound by the SECURE Act’s 10-year distribution rule. As the successor beneficiary, the estate would either have a ‘fresh’ 10 years in which to take distributions from the inherited IRA, or the remainder of the first designated beneficiary’s 10-year distribution period, depending on the type of beneficiary who first inherited the IRA account.
Example: George, age 75, owns a traditional IRA. George dies with his brother, Jeb, named as his primary IRA beneficiary, i.e., Jeb is the designated beneficiary of the IRA. George has also named Jeb’s daughters (George’s nieces) as the contingent beneficiaries of George’s IRA. Jeb, age 73, qualifies as an eligible designated beneficiary because Jeb is less than 10 years younger than George. Nine months after George’s death Jeb dies before he has completed the paperwork necessary to claim George’s IRA. The assets held in George’s IRA are not paid or distributed to the named contingent beneficiaries of the IRA, George’s nieces. Jeb, as an eligible designated beneficiary is deemed to have created an inherited stretch IRA. The IRA custodial document identifies Jeb’s estate as his default beneficiary. An estate-owned inherited IRA is established. Since Jeb was an eligible designated beneficiary who was allowed to stretch required minimum distributions, Jeb’s estate, as successor beneficiary, receives a ‘fresh’ 10-years in which to take distributions from the inherited IRA. Required minimum distributions (RMDs) are required to be taken by the estate from the IRA based on Jeb’s single life expectancy, and Jeb’s estate-owned IRA must be emptied by the end of the 10th year.
Conclusion: We sometimes forget that an IRA is subject to contract law, not necessarily Will and Trust laws. Thus, the importance of the IRA custodial agreement and the presumptions that are made in that custodial agreement that many IRA owners never get around to reading. It gets even more confusing when the law that governs the custodial agreement and its interpretation is another state’s laws. Finally, the potentially long period of time that can occur between when the IRA owner dies and when the IRA’s designated beneficiaries are actually determined and they decide which distribution options to choose, a gap in time when the designated beneficiary’s death might unexpectedly occur, in turn leading to default beneficiaries. It would be helpful to review with clients the terms of their IRC custodial agreement and in particular the default successor beneficiaries.