Dos and Don'ts for Leaving IRA Assets to Your Loved Ones
Some strategies take maximum advantage of an IRA's tax-savings benefits.
Investing Specialists
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report. A version of this article appeared Feb. 28, 2013.
In a previous article, as well as a follow-up column, I waded into the treacherous terrain of inherited IRAs. What happens if a spouse inherits a Roth IRA? What if a nonspouse beneficiary inherits a Traditional IRA and the account owner had already begun taking distributions from it? The permutations--and complications--of this topic are seemingly endless, and some scenarios are definitely better than others.
To help reduce headaches for your heirs and make sure your assets are distributed in accordance with your real wishes, it pays to give due attention to your IRAs' beneficiary designations from the get-go.
Here are some of the key dos and don'ts to bear in mind as you do so.
Do
Check with your estate-planning attorney before naming your IRA beneficiaries.
What's on your beneficiary designation form trumps what's in your will, so it pays to ensure that your named IRA beneficiaries sync up with both the letter and spirit of what's spelled out in your estate-planning documents. A qualified estate-planning attorney should also be able to direct you toward the most tax-efficient uses of your IRA assets and give a red flag to ill-conceived designations, such as naming a minor child or estate the beneficiary of an IRA.
Consider making a charity the beneficiary of your IRA.
Not only will the charity receive the assets tax-free, but your estate will also be eligible for a charitable deduction. By contrast, if you name children or other heirs as the beneficiary of the IRA, they'll pay taxes when they take withdrawals from the account.
Mull a conversion of your Traditional IRA assets to Roth if you don't expect to need the money during your lifetime.
For wealthier individuals who don't expect to need their IRA assets in retirement, converting from a Traditional IRA to a Roth can make sense on a couple of different fronts. First, if you convert all or part of your IRA assets to Roth, you'll no longer have to take required minimum distributions from that account, which will allow those assets to compound tax-free for your heirs. And when your heirs inherit the money, they won't owe any income tax on their withdrawals. Nonspouse beneficiaries will have to take RMDs, as laid out in this article, but they can stretch them over their own life spans.
Coach your spouse on how to handle your IRA assets after you're gone.
Generally speaking, it's going to be most tax-efficient for a spouse to roll inherited IRA assets into his or her own account upon the first spouse's death, thereby stretching out the tax-savings benefits of the vehicle. Younger spouses who expect that they made need the money before they turn 59 1/2 should think twice before rolling the inherited IRA assets into their own IRAs, however, because they'll pay an early-distribution penalty on any assets they withdraw before that age.
Don't
Fail to name beneficiaries for your IRA assets.
What happens if an IRA has no beneficiary designation at all? It depends. Some firms pass remaining IRA assets to a surviving spouse and, if there is no surviving spouse, to the deceased person's estate. Other firms pass the assets directly to the estate. Does that seem a bit too open-ended for your taste? Then name a beneficiary.
Name your estate as the beneficiary of your IRA assets.
Naming your estate as the beneficiary of your IRA is usually less desirable than naming an individual or charity. That's because those who inherit assets from your estate would be required to take distributions from the IRA account within a short period of time--either by the end of the fifth year following the account owner's death, if the deceased had not begun taking RMDs, or in line with the deceased person's own RMDs if he or she had already begun taking them. By contrast, if individuals are named as beneficiaries on your IRA forms, they'll have more flexibility to stretch out the tax-savings benefits.
Neglect to update your IRA beneficiary designations if you have a major life change.
Every estate-planning attorney has a favorite cautionary tale of an estate plan gone awry: The person whose ex-wife inherited all of his assets because he hadn't updated his estate-planning documents to reflect his change in marital status, for example. Don't let that be you. Plan to review your beneficiary designations on a regular schedule, ideally as part of an annual review of your finances. Major life events, such as a marriage, a divorce, the birth of a child, or the death of a loved one may require that you make changes to your designations.
Forget to update your IRA beneficiary designations if you've moved your IRA from one financial-services provider to another.
In a similar vein, you'll also want to review your beneficiary designations if you have recently switched the brokerage firm or mutual fund company where you hold your IRA accounts. You'll usually have to name your beneficiaries on your application form; they won't carry over from one provider to the next.
Name a minor child as the beneficiary of your IRA.
Children under the age of majority--age 18 or 21, depending on the state in which you live--cannot be named as beneficiaries of life insurance policies, retirement plans, or annuities. If you'd like to leave IRA assets to a minor, check with an estate-planning attorney about setting up a trust or a uniform transfers/gifts to minors--UTMA/UGMA--account.
 | Morningstar Individual Investor Conference March 22, 2014 | 9:00 a.m. CDT Position your portfolio for success with the help of Morningstar's investment experts.  |