Options and Pitfalls for Non-spouse Beneficiaries
By Sarah Brenner, JD
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Much attention is paid to the favorable options available when spouses are named as IRA beneficiaries. However, a significant portion of IRA assets will end up being inherited by individuals who are not a spouse of the decedent. Many people name siblings, friends, children or others as their IRA beneficiaries. Also, IRA assets that start off with spouse beneficiaries often end up in the hands of non-spouse beneficiaries. How so? A typical scenario is for spouses to name each other as IRA beneficiaries. After the death of first spouse, the surviving spouse will often transfer the inherited IRA assets to an IRA in their own name. At that point they are likely to name a non-spouse beneficiary if they do not remarry. Because IRA assets frequently wind up being inherited by someone other than a spouse, it is critical to understand both the possibilities and pitfalls for these non-spouse beneficiaries.
When an IRA owner dies, there is no probate or other process necessary to transfer the IRA funds to the beneficiary named on the beneficiary designation form. Instead, the IRA becomes the beneficiary’s property by the fact of the IRA owner’s death. Generally, the beneficiary will provide a death certificate to the IRA custodian. The account will then be retitled as a beneficiary IRA. It is never titled just in the name of the IRA beneficiary.
Example: Tom is a widower. He inherited his wife’s traditional IRA several years ago and rolled it over to his own IRA. He has three children, Lisa, Eric, and Natalie. Tom passes away in 2018.
Tom named his three children as his IRA beneficiaries on his beneficiary designation form. After his death, his children provide a death certificate to the IRA custodian. Beneficiary IRAs are then established for each of his children. For example, the one established for Lisa is titled “Lisa as beneficiary of Tom” or something similar that signifies that the IRA was once owned by Tom.
When a non-spouse beneficiary inherits an IRA, they should proceed with extra caution. “Touch nothing!” is good advice. Non-spouse beneficiaries should be aware of their options and give serious thought to what they want before acting. In some cases, the IRA document will limit the options available.
A non-spouse beneficiary, unlike a spouse beneficiary, does not have the option of rolling over an unwanted distribution. A non-spouse beneficiary who takes a distribution without understanding the tax consequences has no remedy. The ability to stretch distributions from the inherited IRA will be lost forever. Non-spouse beneficiaries do have the ability to move an inherited IRA to a new custodian, but the move must be done by a direct trustee-to-trustee transfer.
Example: After Tom’s death, Lisa and Eric consult with financial advisors and set up inherited IRAs. They do not take distributions from these IRAs. There is no taxable event and Lisa and Eric have not lost their ability to stretch out distributions over their own life expectancies. Natalie, on the other hand, does not consult with an expert and takes a lump sum distribution from her inherited IRA. The distribution is taxable to Natalie and she has lost the stretch. There is no remedy for Natalie if she has second thoughts.
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