Note: This article is part of Morningstar's 2018 Guide to IRAs special report. A version of this article appeared on Sept. 10, 2017.
Deciding who you want to inherit your IRA is straightforward. As with any other asset, the best answer is whoever (or whatever, in the case of charities) is most deserving and would derive the biggest benefit from the money.
Yet the logistics leaving IRA assets to loved ones, a trust, estate, or charity can get complicated; Morningstar.com contributor Natalie Choate, an IRA specialist, frequently writes about the mistakes people make when it comes to making IRA beneficiary designations.
If the Beneficiary Is a Child or Other Loved One
Nonspouses who inherit IRAs can roll the money into an inherited IRA, thereby stretching out the tax-saving benefits over their own lifetimes if they choose to do so. Yet as Choate points out in this article, very few people take advantage of this provision, either because they need the money imminently or because the individual was not named as a "designated beneficiary." If your goal is for a loved one to take advantage of this stretch provision, make sure that you've filled out the beneficiary designation form, not just named the person the beneficiary in your will. (You could check with your estate planner to be sure you've done it properly.) In addition, discuss your goals for a stretch IRA with your adult child or other loved one, to clarify this is what you expect him or her to do with the assets. Finally, it's worth noting that the future of the "stretch IRA" is in question, given that so few individuals take advantage of it.
While it might seem appealing to designate your young children or grandchildren as the beneficiaries of your IRA, bear in mind that minor children can't legally manage those accounts on their own. If you don't take pre-emptive steps to establish who will manage those assets prior to the child reaching the age of majority, the court will decide who will do it. If you'd like to make a child the beneficiary of an IRA, a better idea is to make the child the beneficiary, then specify in your will the name of a custodian to manage the child's financial affairs until he or she reaches a specific age. (The custodian can be the same person as the child's guardian, or it can be someone else.) Alternatively, you could make a trust the beneficiary of your IRA; your trust documents, in turn, can spell out how that money is to be managed and distributed to your heirs. (Below, I cover what happens when trusts are the beneficiaries of IRAs.)
If the Beneficiary Is a Charity
There are a couple of key tax benefits--not to mention emotional benefits--to leaving IRA assets to charity. 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, assuming it's a traditional IRA.
But while naming a charity (or charities) seems like it should be straightforward, complications can arise, as Choate details in this article. One workaround is to name a donor-advised fund the beneficiary of the IRA (or a portion of it); you'd then need to let the donor-advised fund sponsor know how you'd like the assets distributed to the charities of your own choosing.
If the Beneficiary Is Your Estate
This seems like the simple way out, but naming your estate as the beneficiary of your IRA--either via your will or on your beneficiary designation forms--is 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 designated beneficiaries on your IRA forms, as discussed above, they'll have more flexibility to stretch out the tax-savings benefits.
If the Beneficiary Is a Trust
Making a trust the beneficiary of an IRA won't help your estate or your loved ones save on taxes; trusts usually entail extra costs and add complexity to an estate plan. You definitely don't want to make a trust the beneficiary of your IRA unless you have a valid reason to do so. A key rationale for making a trust the beneficiary of an IRA is if the individual you would like to benefit from those assets cannot manage the assets on his or her own. A minor child (discussed above) is a good example. Ditto for loved ones with special needs; not only is it possible that individuals with intellectual disability may not be able to manage the assets themselves, but inheriting assets outright could jeopardize eligibility for government resources that people with disabilities might otherwise be entitled to. Trusts can also be used to ensure that your loved ones take advantage of the "stretch" opportunity for the inherited IRA assets, rather than raiding the accounts all at once. Short answer: If you're considering making a trust the beneficiary of your IRA, get some estate-planning advice to ensure that it's really warranted.