We often advise investors about keeping up with their beneficiary designations, lest accounts like IRAs and 401(k)s or insurance policies fall into the hands of an ex-spouse or left to a beneficiary who has already died. Unfortunately, we came across a situation where an investor did not name a beneficiary for his IRA.
Accounts like IRAs and 401(k)s, life insurance, and annuities generally pass by beneficiary designation outside of your will. Even some bank and investment accounts can be designated as transfer on death (TOD) or pay on death (POD) to a named beneficiary. The advantage is that these assets transfer directly to the heir(s), bypassing probate or settlement of the estate. Heirs of these accounts may also gain certain tax benefits by inheriting via a beneficiary designation. Spouses may treat an inherited IRA as their own, while non-spouse beneficiaries have 10 years to deplete the account.
Without a specified beneficiary on an account, the IRA becomes part of the decedent’s estate. All 50 states and the District of Columbia have laws that govern estate planning, such as validating wills, creation of trusts and the probate process. While some states’ laws are easier than others, probate can be a long process. Probated estates are part of public records, which exposes the retirement account to creditors.
When the retirement account becomes part of an estate, it also becomes subject to estate taxes. However, most estates will not incur estate taxes because of the high estate exemption amount of $12.6 million. If the estate is above the exclusion amount, it will generally be taxed at the top rate of 40%. The estate tax applies to a decedent’s gross estate, which generally includes financial assets, such as investment accounts and real tangible property, such as houses.
Fortunately, in this case, the estate did not owe much to creditors, nor was it above the estate tax exemption amount. The investor’s brother was the sole beneficiary of the estate, as there were no other living relatives. Now, normally, this would be “found money,” so whatever he receives is a happy bonus, right? Because the IRA is now part of the estate, it is subject to a “five-year rule,” where the IRA must be distributed within five years after the account owner’s death. Had the original owner begun required minimum distributions, the IRA could have been distributed over the original owner’s remaining single life expectancy.
Because the IRA was substantial, distributions over the accelerated five years created a difficult tax situation for the brother since distributions are taxed as ordinary income. The heir needed to work closely with a financial adviser and C.P.A., not because of his newfound wealth, but because he had to coordinate his own income, investments, and phased-out deductions with the considerably higher tax bracket the IRA distributions put him in.
In the end, the IRA was subject to considerably more taxes than if it had it passed by beneficiary designation. While the brother was left with an unexpected inheritance, his lasting memory was the tax headaches he inherited. The moral of the story: Fill out the beneficiary designations on accounts that pass outside of your will and estate; otherwise, the IRS will remember you more fondly than your heirs.
If you have questions on your beneficiary designations, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the February 12, 2022 “Henssler Money Talks” episode.