Most people think it is easy to leave an IRA to their heirs. But is it? The following is a quick quiz. How many of these beneficiary questions can you get correct? The answers are at the end of the quiz.
1. The IRA owner has four children. He names the oldest child as the beneficiary of his IRA and the executor of his will which divides all his assets equally among the four children. Who gets the IRA?
2. The IRA owner has met with an attorney who recommends that he establish a trust for his spouse and that he names the trust as the beneficiary of his IRA. Who gets the IRA?
3. The IRA owner and his spouse are both wealthy. They decide that he has enough assets to leave to their heirs and that they will leave her assets to charity. Her will is set up to leave all her assets to charity. The beneficiary form for her IRA says the beneficiary is her spouse. Who gets the IRA?
4. The IRA owner and her spouse get divorced. He remarries and 10 years later he dies. His estate goes to his new spouse. His IRA beneficiary form names his ex-spouse. Who gets the IRA?
5. The IRA owner established her IRA twenty years ago. Today, after numerous bank mergers, she dies. No beneficiary form can be found. Who gets the IRA?
The IRA owner is divorced. He names his minor children as the beneficiaries of his IRA. While they are still minors he dies. Who gets the IRA?
1. The oldest child gets the IRA, and most likely the tax liability. He may be able to disclaim the IRA or gift some of the RMDs to his siblings. A disclaimer generally means that the IRA will go to the estate before going to the siblings which results in much less favorable distribution options.
2. The trust gets the IRA, not the spouse, even if the spouse is the trustee of the trust. RMDs will have to go to the trust first and then to the spouse in accordance with the terms of the trust.
3. The spouse gets the IRA. IRAs do not pass through the will unless the estate is the beneficiary of the IRA.
4. The ex-spouse gets the IRA. IRAs pass by the beneficiary form, not the will.
5. Unless the beneficiaries have a copy of the beneficiary form acknowledged by the bank, the IRA is going to pass in accordance with the default options in the IRA agreement. Some IRA agreements default to the spouse and if no spouse to the children, many agreements default to the estate. The distribution options for beneficiaries who inherit through the estate are far less favorable than the options for beneficiaries who are named on a beneficiary form.
Minor beneficiaries cannot sign paperwork for inherited IRAs, cannot manage the investments and cannot request RMDs. The IRA custodian may require that someone be appointed by a court to handle the inherited IRA for the child until they reach the age of majority or state laws could apply. The court could possibly name the ex-spouse to handle the inherited IRA for the children.
All of these questions describe situations that we see fairly regularly. IRA owners and their advisors need to be aware of the rules that govern how IRAs are inherited in order to ensure that those hard-earned assets pass in the most advantageous way to the correct beneficiaries. Generally, errors in this area cannot be corrected after the death of the IRA owner thus resulting in a significantly reduced inheritance and a corresponding higher tax bill for the beneficiaries.