Beneficiary Planning for Retirement Accounts, Part II – Non-Spouse Beneficiaries

As I mentioned in my last blog, designating a beneficiary that is not your spouse for your retirement plan accounts introduces a more complex set of rules. Non-spouse beneficiaries are subject to different distribution schedules and must follow strict guidelines if they want to “stretch” an IRA’s life (discussed below).

Below is a Q&A that answers the most pertinent questions when it comes to inheriting a retirement account if you are not the original owner’s spouse.

Q. As an IRA owner, who can you name as your account’s beneficiary?
A. You can name anyone you want to as your beneficiary, including children, parents, relatives, and friends. You even can name nonpersons, such as charities. Moreover, there are no restrictions on the number of designated beneficiaries or the amounts left to them.

Account owners residing in community property states may need to obtain spousal consent prior to naming a beneficiary other than their spouse. Your IRA custodian will provide you with a beneficiary form on which you make the designation, and it then becomes your obligation to keep it up to date as life dictates.

Q. What options do non-spouse beneficiaries have upon inheriting an IRA?
A. The beneficiaries need to make decisions on how and when to take distributions from the inherited IRA. Non-spouse beneficiaries generally have three options for handling the proceeds:

  1. Liquidate the IRA. The entire amount then will be subject to federal income tax and state income tax if applicable. An early 10% distribution penalty is not assessed.
  2. Begin taking minimum distributions (based on the beneficiary’s life expectancy) by December 31 of the year following the year in which the account owner died. This option is commonly referred to as a Stretch IRA
  3. Defer distributions until a later date; but then the account must be fully distributed by December 31 of the fifth anniversary year of the original account holder’s death. This option is referred to as “five-year payout” rule. No minimum withdrawals are required during the five-year period. 

Tip: Should you inherit a 401(k), understand that most 401(k) plans don’t offer lifetime distributions (i.e., “stretch”) and instead default to the five-year payout, so it is important to be familiar with the plan’s rules.

It also is important to note that only a spousal beneficiary may take actual possession of the proceeds— for up to 60 days—without being taxed, before rolling them over into an IRA. Non-spouse beneficiaries do not have this ability, and the assets, once distributed, are taxable immediately and cannot subsequently be rolled over to an IRA. The account effectively is liquidated. Non-spouse beneficiaries who do not want to take a full, taxable, distribution must move the assets to an inherited IRA directly via a trustee transfer. If they take possession of the proceeds for any amount of time, they will be taxed.

If a nonperson, such as a charity, also is named as one of the primary beneficiaries, it is important to have the nonperson’s portion distributed by September 30 of the year following the death of the account owner. Failure to do so will result in the human beneficiaries being locked into the five-year payout rule described above.

Q. How does a non-spouse beneficiary establish an Inherited IRA?
A. Contact your existing IRA custodian for information. In general, the beneficiary completes paperwork authorizing the establishment of an inherited IRA. The account should be registered using the beneficiary’s Social Security number, not the deceased’s. The inherited IRA should be registered as follows:

  • Name of deceased and date of death
  • FBO: Name of beneficiary and Social Security number

Q. Which required minimum distribution (RMD) rules apply to non-spouse beneficiaries?
A. Whether there is one beneficiary or a multiple, the required minimum distribution amount remains the same. Differences may arise, however, in which life expectancy to use in the calculation, because it depends on the ages and types of beneficiaries named.

First, determine what the age of the oldest or only beneficiary will be in the year following the death of the original account holder. That age has a corresponding life-expectancy factor drawn from the Single Life Expectancy Table, found in IRS Publication 590 Individual Retirement Arrangements.

For example, the life expectancy of a 45-year-old beneficiary is 38.8 years. The account balance on December 31 of the prior year is divided by this factor (38.8) to determine the minimum distribution amount for that year. The process repeats each year as the life-expectancy factor is reduced by one (37.8, 36.8, 35.8, and so on), while the year-end account balance is adjusted. The life expectancy of the oldest beneficiary is imposed on all beneficiaries, regardless of their age, unless the accounts are “split,” meaning each named beneficiary opens his or her own inherited IRA account, and can subsequently you their own age for the life-expectancy factor (see next question).

It is recommended that beneficiaries designate their own beneficiaries to receive the balance of their payments should they not survive the full payout term. A new or second beneficiary would continue taking distributions where the prior one left off. For example, if the first beneficiary in this hypothetical example passed away after receiving one payment, his beneficiaries would use the 37.8 factor (38.8  minus 1) to determine the minimum to be distributed each year. A factor of 36.8 would be used in the following year, and so on. In other words, second-generation beneficiaries cannot use their own life expectancy. Instead, they are required to use the remaining life expectancy of the original beneficiary.  

Note that a beneficiary generally can take more than the minimum withdrawal amount.

Q. What if there are two or more named beneficiaries?
A. When there are two or more named individual beneficiaries, each can choose to transfer the proceeds over to separate inherited IRA accounts (referred to as “splitting”). As long as each beneficiary establishes a separate inherited IRA prior to December 31 of the year following the original account holder’s death, each beneficiary is able to utilize his or her own age for purposes of stretching the RMD payouts. If the accounts are not “split” by December 31 of the year following the account owner’s death, minimum withdrawals are required, and calculated by using the life expectancy of the oldest beneficiary.

Q. What happens when a minor is a designated beneficiary?
A. When minors are named beneficiaries, the options and minimum distribution requirements are exactly the same as a named adult beneficiary. For example, a 12-year-old sole primary beneficiary would use the life expectancy for a 12-year-old (70.8 years) to determine the initial minimum distribution amount.

A minor beneficiary, however, can become problematic, since the IRA provider cannot distribute the proceeds directly to a minor, who is not able to make tax decisions. Therefore, it is wise for the account owner to create a trust for the benefit of the minor. The trust would be the named beneficiary. The trustee would be responsible for making decisions (e.g., tax, investments, etc.) on behalf of the minor. In the absence of a trust, the IRA custodian could not make any distributions from the account until a guardian is authorized by the probate court (generally determined by state law).

Tip: Account owners should not move their IRA assets into the trust or retitle their IRA into the name of the trust while they are still alive. Why? These actions are deemed taxable events, and, therefore, the owners will owe income tax on their entire IRA account value. (Ouch!) Instead, the trust simply should be named as the original beneficiary on the beneficiary form

Q. What are some potential pitfalls a non-spouse beneficiary should be aware of?
A. As a non-spouse beneficiary, you are not permitted to:

  1. Take a distribution via a 60-day rollover. Instead, assets must be moved immediately via a direct trustee transfer.
  2. Convert an inherited traditional IRA to an inherited Roth IRA. Only spousal beneficiaries are allowed to do this.
  3. Roll over an inherited IRA to your own IRA. Instead, an inherited IRA must be kept separate from your own IRA, assuming you have one.

One of the biggest tax advantages available to retirement plan owners is the ability to preserve and pass on the tax status of the accounts that are inherited. However, this golden opportunity can be forfeited if the beneficiary forms are either not in good order or not completed. A minor plan error or oversight can end up costing heirs significantly. We urge investors to meet with their advisors to review and update their beneficiary forms on all retirement accounts as often as necessary.