Estate as Beneficiary of Traditional IRA or Retirement Plan
What is it?
Generally, following your death, your nonretirement assets will pass according to your will or trust or beneficiary designations (e.g., life insurance). If you do not have a will or trust or there is a gap in your beneficiary designations, the laws of your state (or the state where you own real property) will generally determine your heirs.
With IRAs and employer-sponsored retirement plans, when you die, the remaining funds generally pass directly to the beneficiary (or beneficiaries) you have designated. Spouses, children and grandchildren, trusts, and charities are common beneficiary choices. However, if you have a gap in your beneficiary designations, your estate may become the "default" beneficiary of your IRA and/or retirement plan benefits. This could occur, for example, if all of your designated beneficiaries die before you, and then you die before naming a new beneficiary.
With your estate as the beneficiary of your IRA or plan, the money in the account is first distributed to your estate, and then passes to your heirs according to the terms of your will. Having your estate as beneficiary is usually the worst possible beneficiary choice in terms of tax implications. In addition, you will sacrifice some planning options and potentially expose the retirement funds to extra fees, risks, and creditors.
This discussion applies to traditional IRAs and employer-sponsored retirement plans. Special considerations apply to beneficiary designations for Roth IRAs.
Having your estate as beneficiary will not affect required minimum distributions during your life
Under federal law, you must begin taking annual required minimum distributions (RMDs) from your traditional IRA and most employer-sponsored retirement plans (including 401(k)s, 403(b)s, 457(b)s, SEPs, and SIMPLE plans) by April 1 of the calendar year following the calendar year in which you reach age 73 (age 75 if you reach age 73 after 2032), known as your "required beginning date." With employer-sponsored retirement plans, you can delay your first distribution from your current employer's plan until April 1 of the calendar year following the calendar year in which you retire if (1) you retire after age 73 (age 75 if you reach age 73 after 2032), (2) you are still participating in the employer's plan, and (3) you own 5% or less of the employer.
Your choice of beneficiary generally will not affect the calculation of your RMDs during your lifetime unless your spouse is your sole designated beneficiary for the entire distribution year, and he or she is more than 10 years younger than you. But note, however, that having your estate as beneficiary will generally result in limited options (and the fastest possible payout) for required post-death distributions. See below for additional information.
The calculation of RMDs is complex, as are the related tax and estate planning issues. For more information, consult a tax professional.
Advantages of having your estate as beneficiary
There are virtually no advantages to having your estate as the beneficiary of your traditional IRA or retirement plan.
Disadvantages of having your estate as beneficiary
Post-death distribution options are limited and generally unfavorable
If your estate ends up as your IRA or retirement plan beneficiary at your death (either because you intentionally named your estate as beneficiary, or by default because you died with no living individual named as a beneficiary), you will be treated as if you died without any designated beneficiary. Required post-death distributions from the account will therefore have to be made at the fastest rate possible, potentially increasing the total income tax liability on the funds. And the more rapidly the funds must be distributed from the IRA or plan, the less time they have to continue growing in a tax-deferred environment. Here are the specific rules you should be familiar with:
- If you die prior to your required beginning date for RMDs with your estate as beneficiary, the IRA or plan funds must be distributed within five years after your death (the "five-year rule").
- If you die after your required beginning date for RMDs with your estate as beneficiary, the IRA or plan funds must be distributed over your remaining single life expectancy, calculated in the year of death (maximum of about17 years)
The 5-year period for defined contribution plans (other than Section 457 plans for non-governmental tax-exempt organizations) and IRAs is determined without regard to calendar year 2022. Thus, if the decedent died in 2017 to 2021 and distributions are subject to the 5-year rule, 2022 would be within the 5-year period and the 5-year period would effectively be extended to 6 years.
If instead you named a spouse, child, other individual, or qualifying trust as beneficiary, post-death distribution options would be more favorable. For decedents dying before 2020, these beneficiaries would generally have the option of taking required post-death distributions over a longer period by using their own remaining life expectancy. For decedents dying after 2019, the life expectancy method can only be used if the designated beneficiary is an eligible designated beneficiary. An eligible designated beneficiary is a designated beneficiary who is the spouse or a minor child of the IRA owner or plan participant, a disabled or chronically ill individual, or other individual who is not more than ten years younger than the IRA owner or plan participant (such as a close-in-age sibling). (Spouses have more options, such as the ability to roll over the inherited funds into the spouse's own IRA or plan.) A longer post-death payout period will help spread out the income tax bill on the money, and further prolong tax-deferred growth.
In the case of a qualifying trust as beneficiary of an IRA or plan, if the election is made to base post-death distributions on the beneficiary's life expectancy, the oldest beneficiary of the trust (i.e., the one with the shortest life expectancy) generally must be used for this calculation.
The funds will have to pass through probate
If you die with your estate as the beneficiary of your IRA or retirement plan, the funds will have to pass through probate before being distributed to the heirs of your estate. Probate is the court-supervised process of administering an estate and also possibly proving a will to be valid. It is sometimes a costly, time-consuming process that is open to public scrutiny, and may also needlessly expose the retirement funds to creditors. However, if you designate an individual or a qualifying trust as the beneficiary of your IRA or retirement plan, the inherited funds will pass directly to that beneficiary without having to go through probate. This is often a compelling reason not to name your estate as beneficiary of your IRA or plan.
Estate tax issues
You may be concerned about possible estate tax issues if you expect the value of your taxable estate to exceed the federal applicable exclusion amount. After your death, the funds remaining in your IRA or retirement plan will be included in your taxable estate to determine if any federal estate tax is due. This is generally true regardless of whether you have named your estate, an individual, or a trust as beneficiary. In addition to federal estate tax, your state may impose a state death tax.
Estate taxes and other estate planning issues are highly technical areas. Be sure to seek professional assistance from a qualified estate planning attorney.
