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Taking mustery out of IRA beneficiary rules

Updated: May 3, 2013 12:14PM

Originally published: August 1, 2007

Every year, billions of dollars pour into 40l(k) plans. One day, the participants will retire and roll over their assets into individual retirement accounts. In fact, many people already have done so, and they are confronting issues that range from investment choices to withdrawal techniques for these ever-growing pools of money.

The government puts strict rules - and big penalties - on IRAs, yet most people must face these decisions without much help.

Last week, this column dealt with your IRA withdrawal choices.

This week, we’ll take a look at naming beneficiaries - a decision that could have big tax implications, either at withdrawal time or upon the death of the IRA owner.

There are two key taxation rules to keep in mind. The first is that you, or your beneficiary, will owe federal income taxes on IRA withdrawals as they are made (except for Roth IRAs). Only if the beneficiary is a charity will this ordinary taxation be avoided.

There are, however, ways to minimize the income taxes and allow the beneficiary to let the account continue growing.

The second key issue is estate taxes. Your IRA (even a Roth IRA) is definitely part of your estate when you die. In fact, for many retirees who rolled over corporate retirement accounts, the IRA is the largest asset in the estate, dwarfing even the value of the family home. Even though an IRA generally does not pass through probate (the process of changing title to the account), it is considered part of the estate’s total value.

The basic rule of estate planning is that estate assets over $650,000 (in 1999) are subject to federal estate taxes that quickly rise to 55 percent. Married people typically name their spouse as beneficiary of their IRA. That makes sense because assets passed to a surviving spouse are exempt from estate taxes. But on the death of the surviving spouse, the estate tax will be levied on the assets.

So if you and your spouse have reached this level of total family assets, some tax planning will required.

One typical way to mitigate these estate taxes is to set up a separate and irrevocable trust, making gifts up to the limit of $10,000 a year per person, and having the independent trustees purchase life insurance for you and your spouse. That cash, which will be outside the estate, can then be used to pay estate taxes.

Naming a beneficiary

Even after you’ve discussed the estate planning issues, there are still some tax considerations in naming the beneficiary - and in the choices the beneficiary must make regarding withdrawals when the IRA owner dies.

As noted in last week’s column, you can stretch out withdrawals over two combined life expectancies, if you name an individual as a beneficiary. But if you name a charity as ultimate beneficiary, you must start withdrawing larger amounts when you reach age 70 1/2. You might be better off leaving other assets to a charity, or making the charity the beneficiary of a life insurance policy. Again, ask your tax adviser.

If you do name either your spouse or another person as your IRA beneficiary, you should make sure he or she understands all of the options and rules regarding withdrawal.

There are different sets of rules for spousal beneficiaries. And the rules change, depending on whether you start a systematic withdrawal program before you die. You might want to leave this explanation with your beneficiary designation. Here are the options in each case.

If your spouse is your IRA beneficiary, the spouse can take the IRA and treat it as his or her own. Your IRA becomes a spousal rollover. The spouse can name new beneficiaries. If you had not started a withdrawal plan, the spouse must start withdrawing by April 1 of the year after he or she reaches 70 1/2.

If you, the owner, already had started withdrawing money from the IRA, your spouse has two choices. If younger than you, he or she can wait until April 1 of the year after reaching 70 1/2. But if he or she is already older than 70 1/2, withdrawals must start by Dec.

31 of the year after the owner’s death.

There is a special consideration for younger spouses who are beneficiaries of an IRA and might need to start early withdrawals from the IRA. They should not roll the IRA into a spousal IRA because withdrawals before age 59 1/2 would then trigger a 10 percent federal tax penalty.

Younger spousal beneficiaries might ask to be treated as a standard beneficiary, using the rules described below.

Beneficiaries other than spouses have different withdrawal requirements and rules when the IRA owner dies. If the owner dies before beginning required withdrawals, there are two options. The most frequently used - but not necessarily the best idea - is based on the fact that the beneficiary can wait until Dec. 31 of the fifth year after the IRA owner’s death. Then all of the money must come out. Of course, that creates a big tax bite in one year.

The other choice for this non-spousal beneficiary (when withdrawals have not started by the IRA owner) is to take the first distribution by Dec. 31 of the first year after the owner’s death.

Yes, that will trigger ordinary income taxes sooner. But, regardless of the beneficiary’s age, the distributions can continue over the life expectancy of the beneficiary. Thus, the tax bite would come sooner - but the ultimate period of withdrawals might be stretched out over a far longer period, allowing the assets to continue to grow.

If the IRA owner already had started to take required distributions, the rules are much more limited. In that case, a non-spousal beneficiary must start taking distribution by Dec. 31 of the year after the owner’s death.

Calculating the distribution

But here’s how the required distribution is calculated: You take the beneficiary’s life expectancy from the Internal Revenue Service tables - but not the beneficiary’s current life expectancy. You want the beneficiary’s life expectancy at the age when the original owner turned 70 1/2. From that number, you subtract the number of years that the owner had taken distributions. The resulting number becomes the divisor that determines how much must continue to be withdrawn from the IRA every year by the beneficiary.

Yes, the numbers are confusing and the methods are confounding.

Every year, more and more Americans will be confronted with these rules for beneficiary withdrawals from IRAs.

The responsibility sits directly with the IRA owner and beneficiary to make the right decisions. Most custodians avoid offering this type of advice. So surely Congress must act to make things easier.

In the meantime, I suggest you check in at, where accountant Ed Slott answers hundreds of questions every month about IRAs. Or you can subscribe to his monthly newsletter, Ed Slott’s IRA Advisor (800-663-1340).

It would be a shame to have worked all your life to build and invest your retirement funds, only to see them disappear in unnecessary taxes and penalties simply because you and your beneficiaries didn’t know the alternatives.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at savage Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.

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