While IRAs are common, flexible vehicles for retirement savings and great planning tools, the beneficiary distribution rules are complicated, and became even more so with the passage of the SECURE Act in December. IRAs often represent a significant portion of a person’s investment portfolio; naming the beneficiary or beneficiaries is an important decision and worthy of review now that this new law is in effect.
Working with clients over many years, I have found that the most common IRA beneficiary designation is to name the spouse when the account owner is married. Surviving spouses are given some special options under the IRS rules that provide more flexibility than what other beneficiaries receive. When it makes sense to name a spouse, this is also the most tax efficient manner to pass on assets from a Traditional IRA where distributions are required to be made at some point, and are taxed as ordinary income.
One of the major changes under the SECURE Act was to change the rule allowing most beneficiaries to “stretch” inherited IRA distributions over the life expectancy of the beneficiary. Under the new rules, if the account owner dies in 2020 or after, most beneficiaries are now required to deplete the inherited IRA within 10 years of the year in which the account owner dies. There are a few exceptions to this, including surviving spouses, where distributions can still be spread over the life expectancy of the spouse beneficiary, thereby spreading out the tax payments. For determining the surviving spouse’s required minimum distribution, the survivor can still use the IRS calculation table that is based the survivor’s age and someone 10 years younger, reducing the taxable amount the surviving spouse must take each year.
A surviving spouse beneficiary has the option to treat all or a portion of their deceased spouse’s IRA as their own, or to take it as an inherited IRA as other beneficiaries are required to do. By taking the IRA as his or her own, the surviving spouse can name his or her own beneficiaries. If that is a concern for the account owner, there are other options to consider and weigh against implementation costs and tax considerations, as described later.
If the surviving spouse beneficiary is over the age of 72, which is the new required beginning date for Traditional IRA distributions under the SECURE Act, it often makes sense to take the deceased spouse’s IRA as the surviving spouse’s own IRA. This can simplify required distributions by combining the deceased spouse’s IRA with the surviving spouse’s own IRA in to one account, with one minimum distribution calculation each year. The penalty for failure to take at least the minimum required amount is 50% of the amount that should have been taken, so keeping things simple can help prevent costly errors. Also, by making the IRA the surviving spouse’s own IRA, the IRA is treated as a new IRA owned by the survivor. Under Michigan law, the new IRA is protected from creditor claims of the surviving spouse. This is not the case with an inherited IRA, whether the surviving spouse or other individuals are named as beneficiaries.
For surviving spouse beneficiaries who are younger and might need financial support from the IRA, it can make sense to take all or a portion of the deceased spouse’s IRA as an inherited IRA. The surviving spouse has the flexibility to delay taking distributions until the year in which the deceased spouse would have turned age 72; this option to delay distributions is not allowed for non-spouse beneficiaries. If funds are needed for the surviving spouse’s support, the normal 10% penalty for taking distributions prior to age 59½ does not apply in this situation. The surviving spouse beneficiary still has the option to spread distributions over his or her own life expectancy. The surviving spouse who elects the inherited IRA option also has the flexibility to choose to roll over the inherited IRA in to his or her own IRA at some future date, and to name his or her own beneficiaries when that is done. The timing of this decision can be important if distributions are being taken, since the 10% penalty will apply if distributions are taken from the surviving spouse’s own IRA prior to age 59½.
For those account owners with concerns about allowing the surviving spouse to name his or her own beneficiaries, perhaps those in a second marriage with children from a first marriage, there is the option of naming a trust as beneficiary. This might involve some initial costs to assure the trust is designed as a “conduit” for the required minimum distributions to be distributed to the surviving spouse, and eventually to the remainder beneficiaries, to prevent unintended negative tax consequences. (Trusts have compressed marginal income tax brackets that often cause a trust to be taxed at a much higher rate than individuals.) If the trust named as beneficiary of the IRA is constructed properly, the surviving spouse is required to receive the required minimum distributions annually, calculated based on the surviving spouse’s life expectancy, and taxed at the surviving spouse’s tax rate. There will be creditor protection for the survivor, and some assets will likely remain for remainder beneficiaries (perhaps children of the first marriage) who are named by the IRA account owner who created the trust. If the trust is not constructed in this manner (called an “accumulation trust”), full depletion of the IRA will be required within 10 years of the account owner’s death, and will be taxed at the (usually) higher trust tax rates. For those account owners who have previously named a trust as beneficiary, it would be wise to review the terms of the trust to assure appropriate conduit provisions that meet the requirements of the SECURE Act are in effect.
Another option for IRA account owners who want to provide for the surviving spouse but who are also charitably inclined is to create a “charitable remainder trust” (CRT) and name it as the beneficiary of the IRA. The CRT is a split interest trust that can be designed to pay distributions for the lifetime of the surviving spouse, with the remaining balance to be distributed at the surviving spouse’s death to charities named by the IRA account owner who created the CRT. The calculation of the CRT distributions to the surviving spouse is not done based on IRA minimum distribution rules, but rather is based on 10% of the initial value of the IRA balance that is earmarked for the charitable remainder interest. At the IRA account owner’s death, the entire IRA balance is paid to the CRT. Since the IRS basically treats the CRT as a charity, this type of trust does not normally pay income taxes. While distributions to the surviving spouse beneficiary are taxable, those distributions are made over the beneficiary’s lifetime, effectively “stretching” the distributions and spreading the tax payments over time.
If you have read this far, by now you are probably convinced that IRA distributions to beneficiaries are complex, and this information has only covered options for naming a spouse as beneficiary. In all of the complexity, at a very basic level, please know that the SECURE Act has significantly changed the rules for IRA beneficiary distributions and this is a good time for all IRA account owners to review who is named as beneficiary. Each family situation is different, and your Client Centric Team at Greenleaf Trust is eager to understand your intentions and to find a solution that meets your goals.