Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Who you name as a beneficiary for your IRA is an important and surprisingly complicated decision. Joining me to discuss this topic is Ed Slott; he's an IRA expert and a best-selling author. Ed, thank you so much for being here.
Ed Slott: Great to be here. Thanks.
Benz: Let's start with this important topic of IRA owners who want to name beneficiaries for their accounts. I'd like to see if you can offer some tips for them. Let's start with one of the most common situations: a married person, his or her natural inclination would be to name the spouse as a beneficiary. When is this appropriate, generally speaking?
Slott: In most cases. That's what most people want to do. They name their spouse on everything. So, you're right; that's what most people do.
Benz: So, are there [instances] when you would not do this, when this wouldn't be a good idea?
Slott: Sure. When you don't want to leave the money to your spouse. It might sound funny, but let's say it's a second marriage. You've already provided maybe some other income to that spouse, and you want your children from your first marriage to get your IRA so they can stretch it. So, there are situations. It's not all about taxes. The first thing you want to ask is, "Who do I want my IRA to go to?" Then, we work from there. But you're right--most times, it's the spouse. But also, you might have a spouse who's incapacitated or can't handle money, and you could still leave it to that spouse, say, through a trust.
Benz: We'll talk about trusts in a minute. But first, I wanted to get your sense of what the benefits are for spouses who inherit IRAs. What are the key advantages from a tax standpoint as well as inheriting those assets?
Slott: Well, I always say the spouse, according to the tax rules, is like the queen in a chess match; she or he can pretty much do anything and has advantages that other nonspouse beneficiaries don't have. The biggest one is the ability to do a spousal rollover, where, let's say, the husband dies and the wife can just roll it over to her own IRA or retitle it as her own IRA. That's a big advantage because, let's say, the spouse [who is inheriting the IRA is] only 65 years old. She doesn't have to start taking distributions until she would have turned 70 1/2.
A spouse also has the ability to remain as a beneficiary; she can go both ways--either do a spousal rollover, treating it as her own, or if she wants to, she can remain a beneficiary. The benefit there is, if the spouse is what the tax law refers to as a younger spouse--young, for tax law, is under 59 1/2. If you are under 59 1/2 and you inherit as a spouse, you are better off staying a beneficiary. The reason is, if you need some of that money, you can take it out penalty-free. Still pay the tax, but it's penalty-free, even though you are under 59 1/2. Then, once you are 59 1/2, a spouse has the additional ability to go back now and do a spousal rollover. There is no deadline for a spousal rollover. So, a spouse has huge advantages when it comes to inheriting IRAs.
Benz: So, huge tax advantages there. There may, however, be situations for a single person or someone who for whatever reason doesn't want to leave the money to a spouse--where you may leave money to a nonspouse beneficiary. What are the key things that people should think about in this case? Let's focus primarily on children and grandchildren, because I would expect that those would be some of the most common people to inherit IRA assets.
Slott: Yes, as I said, in a situation where the spouse is either provided for or doesn't need it--maybe has his or her own assets, so you just don't want to leave that spouse the money--he next natural choice is your children and grandchildren. But the key to all of this is actually naming them on the beneficiary form. By naming the children or grandchildren, whoever you want, they get to do something called "stretch"--extend distributions over their lifetime, once they inherit. And that gives them two big benefits: They spread out the tax over many, many years, and the account grows more rapidly because it's deferred longer from taxes. And if it's a Roth IRA, it's tax-free--even better.
Benz: So, what happens if the person does not chose that stretch option?
Slott: They don't have to. The other option is they can just take more than they have to. Remember, the stretch is the minimum that your children must take after death, and somebody will have to instruct them on how to set up the inherited IRA and the potential benefits. But they could always take more. I have a lot of clients who tell me their kids are not even going to wait for the funeral to end. They'll just take it all. So, you have to know your own family. If you think they are going to just take it and squander it, again, you may want to put more restrictions on that through naming a trust.
Benz: Now, how about minor children? I have a feeling you'll mention a trust in this context as well. If someone has children who are minors--and the age will depend on the state in which they live--but if they have minor children, what should they bear in mind if they are thinking about naming those kids as beneficiaries?
Slott: Again, if you want to name the minor children--a 3- or 4-year-old grandchild or child--go ahead and do it. Tax laws shouldn't drive who you want to leave your money to. But obviously, even a 3-year-old has required distributions, and as smart as you think your 3-year-old might be, they are not going to walk into the bank or broker and say, "Give me my required distribution." Obviously, somebody has to do that for them. So, you can set it up as a gift to minors or transfers to minors or through a trust. The difference is if you set it up as a gift or transfer account, when they are 18 or 21, it's theirs and they can take whatever is left. With a trust, you can control distributions for the rest of their lives even after your death, obviously.
Benz: So, you can put some guidelines around it regarding when the child could take the distributions.
Slott: Right. On what circumstances. A trustee would be required; that's another thing you have to consider--somebody to put your plans into action.
Benz: You've mentioned a few situations when a trust may be appropriate. Are there any others that are important to keep in mind or pitfalls to avoid when naming a trust as a beneficiary of an IRA?
Slott: This is a very common question that we actually get from not only clients and financial advisors. Naming a trust as an IRA beneficiary has, as you said, advantages and disadvantages. When should you name a trust? It comes down to when you want--you being the person with the IRA, the IRA owner. You have a large IRA, maybe $1 million or $500,000 or more, and you don't want it squandered after death. So, it comes down to postdeath control. And that's in a situation, as we just said, where you have a minor beneficiary, a disabled beneficiary, an incompetent beneficiary, an unsophisticated one--a beneficiary you feel may be vulnerable to predators--or a beneficiary who just might not be good managing money, and that could even be a spouse.
So, those are reasons to name a trust. But there is a trade-off; trusts come with complexity. There are a lot of tax rules to follow. It's costly to set up and maintain. You have to file annual tax returns, there are trust administrations, and certain trusts could actually accelerate high taxes because trust tax rates are a highest in the land.
So, those are some of the reasons for and against. But again, do what you want to do, and if you think you need some level of postdeath control, naming a trust would be the way to do it. And the trust has to be implemented properly after death. So, even when people do everything right, after death we see lots of mistakes where the trust blows up.
Benz: So, make sure that you are getting good advice as well as your family or your beneficiaries--make sure that they are getting good advice after you have passed.
Slott: Definitely. You need somebody who has specialized knowledge. Even an average estate-planning attorney might not be familiar with the specialized nuances of naming a trust as an IRA beneficiary. IRAs are different from all other assets inherited. For example, if you inherit a house, there is no rule that the first year the bathroom has to come out, the second year the kitchen has to come out, and on and on. But with IRAs, money has to come out, and it's taxable. And if you don't follow the rules, there are heavy penalties and a lot of the money could end up going right back to the government.
So, you really need someone who specializes in IRA trusts. Not many attorneys do--not many advisors know about this. And I know that because I teach more advisors on this than anyone in the country, and there are always questions on naming a trust and implementation. There are three stages when you have a trust: Should I or should I not name a trust? And we just went through to advantages and disadvantages. Then, setting up the type of trust--what kind of access you want for the beneficiary? How rigid do you want to make it? And then after death, the most important part is implementing the trust. Knowing how to move the IRA assets properly, title them properly, and distribute them properly from the inherited IRA to the trust, to the trust beneficiaries.
Benz: Let's discuss the idea of making a charity the beneficiary of an IRA. It seems like, from many standpoints, this can be a good idea for people who are charitably inclined.
Slott: You said it perfectly. If you are charitably inclined, the IRA is the best asset to give to a charity. Now, you can't give your IRA to a charity during life other than one provision; there's qualified charitable distribution, which as of today, has still not yet been extended. But it probably will be. Other than that, you would leave your IRA to a charity. And the reason I say the IRA is the best asset to give to charity is because it's loaded, infested--not invested. What I call "infested with taxes." Give that to the charity; they don't pay the taxes, so it's a great asset to give to charity.
Benz: Let's talk about whether it's possible to leave pieces of the IRA to different entities. [By that, I mean is it] possible to leave some to the spouse, some children or grandchildren, and some to charity as well?
Slott: Sure. I recommend doing separate IRAs for that. I don't like mixing beneficiaries on one IRA unless it's all three children. Because I see too many mistakes postdeath. I know it sounds easy: I could do one IRA, leave 20% to my spouse, 20% to children and, say, 60% to a charity or whatever, and everything will work out fine. It doesn't. If you want to leave an IRA to a charity, name the charity as the direct beneficiary in that IRA for that amount and only the charity. And then split your IRA.
So, have several IRAs. It will be a lot cleaner after death. And if you want one for your spouse, make that just for your spouse. And if you want one for two, three, four or five kids, the children you could bunch together. You can absolutely name separate beneficiaries, but I would do that on separate IRAs to avoid the postdeath problems I see in the real world.
Benz: Good advice. Last question for you Ed: If a person has Roth assets that they would like to leave to their loved ones or perhaps a charity, what are the key considerations there?
Slott: Don't leave a Roth IRA to a charity. Never, never, never. You already paid the tax. I just said the Traditional IRA was the best asset to leave to a charity because it's loaded with taxes. Why would you pay out all the tax to get money in a Roth IRA, then leave it to charity? So, that's one thing. Never leave a Roth IRA to charity. But the Roth IRA is the best asset to leave to a trust. When you have to name a trust as your IRA beneficiary, it can alleviate the trust tax problems I just talked about. And also, even if you are not leaving a Roth IRA to a trust, you can leave a Roth IRA to children, and they still have to take required distributions. This is a tricky part because most people know that Roth IRAs will have no required distributions during their lifetime. But they do after death.
So, you just have to remind your children, if they are inheriting, that the distributions they inherit will be tax-free, but they have to take them. Otherwise, there is 50% penalty. Can you imagine a child getting a 50% penalty for not taking a distribution from an inherited Roth IRA that would have been tax-free anyway?
Benz: Ed, thank you so much. This is a really tricky area. We appreciate you being here to share your expertise. These are all great insights. Thank you again.
Slott: Thank you, Christine.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.