DON’T Make Your Estate the Beneficiary of Your IRA or Retirement Account!
The adage “you don’t know what you don’t know” often proves to be costly, and for Gertrude, this reality may lead to significant financial consequences. Despite her good intentions, her current course of action could cost her thousands of dollars in unnecessary taxes and delays.
After inheriting $432,000 from her late husband’s IRA, Gertrude opted not to continue working with his advisor, with whom she never felt a strong rapport. Instead, she enlisted the help of a friend to set up a new online IRA at a large brokerage firm. However, uncertain about how to designate her beneficiaries—particularly given her estranged relationship with her stepchildren—she simply listed her “estate” as the beneficiary. Gertrude believed she could sort out the details when she eventually met with her attorney to establish a new will.
What Gertrude didn’t realize, however, is that naming her estate as the beneficiary was a costly misstep. It should also be noted that if there is “a gap in your beneficiary designation, your estate may become your “default” beneficiary of your IRA and/or retirement plan benefits. This could occur, for example, if all of your designated beneficiaries die before you, and then you die before naming a new beneficiary.”[i] In Gertrude’s case, this naming of her estate as the beneficiary could result in her IRA being subject to probate, additional taxation, and unnecessary legal costs—precisely the outcomes she sought to avoid. Had she sought professional guidance earlier, Gertrude would have been aware of these risks and could have taken steps to secure a more efficient plan for her estate.
The Tax Problem
One of the most significant issues with Gertrude’s decision to designate her “estate” as the beneficiary of her IRA is the substantial income tax liability this arrangement would trigger. When a “non-individual” is the beneficiary of an IRA, the distribution process is governed by different rules. “With your estate as the beneficiary of your IRA or [retirement] plan, the money in the account is first distributed to your estate, and then passes to your heirs according to the terms of your will.”[ii] But the worst part is that income tax must be paid by the estate. Because the IRA was initially funded with pre-tax contributions, the taxes that were avoided in earlier years must now be paid by the estate, as transferring those funds into the estate is treated as income for tax purposes. Unfortunately, the estate faces especially unfavorable tax treatment due to their compressed tax brackets.
For Gertrude, the consequences are stark. The majority of her $432,000 IRA would be subject to the highest tax rate of 37% since in 2024, estate income taxes are paid at this rate once income exceeds just $15,200.[iii] (To put this into perspective, for individual taxpayers filing in 2024, the 37% tax bracket isn’t reached until income is above $609,305, or if married filing jointly, $731,200.) As a result, Gertrude’s estate would incur an income tax liability of nearly $158,000 on those IRA dollars, leaving less than $275,000 in net beneficiary distributions for her heirs.
Charitable giving
“But what if Gertrude just wants all her IRA money, the full $432,000, to eventually go to her favorite charities and none to her estranged stepchildren. If her estate makes several charitable contributions, aren’t they deductible for estate income tax purposes?”
“Maybe!” Income tax charitable deductions for estates are substantially different from the rules for charitable deductions for individuals and fall under a different IRS code section. The estate’s governing document, the will, must provide specific language for payments to charity during the administrative period otherwise the estate cannot deduct those gifts for income tax purposes.[iv] This requires the work of a sophisticated estate attorney and can be very nuanced.
There’s a better way
Gertrude should not rely on her will to distribute IRA dollars to heirs. Instead, it is essential that the intended heirs are designated as beneficiaries on the IRA application. If any changes occur, a new beneficiary form must be completed, as the IRA custodian will follow the most recent signed version for distributions. Modifying beneficiaries through the custodian’s form is far more efficient than making such changes through a will, which would require the addition of a codicil or the drafting of a new will.
If Gertrude prefers to retain her IRA assets, anticipating future needs, but wishes to exclude her estranged children (or if she has no children or close relatives) and instead directs the entirety of her IRA to charitable causes upon her death, it is advisable to designate those charities as beneficiaries on the custodian’s form. She may also consider utilizing a foundation to manage the distribution of funds to the respective non-profits, thereby streamlining the process. Once again, altering the charitable beneficiaries during her lifetime is significantly easier through the foundations or custodian’s forms than through revisions to her will.
The Bottom Line
Naming your estate as the beneficiary of your IRA or any other retirement accounts is usually the worst possible beneficiary choice. While it may seem like a convenient option when filling out the initial application, sacrificing some planning options, the potential for extra fees,risks, increased taxes, delays, and administrative burdens far outweighs the simplicity of this choice. In estate planning, as in life, ignorance is seldom bliss; it’s a reminder that a proactive approach saves not only money but peace of mind.
Moreover, don’t navigate these complex decisions on your own. Enlist the help of a qualified financial advisor who understands your unique circumstances and can provide tailored guidance. Such expertise can help ensure that your estate plan offers clarity, security, and confidence in knowing that you are making sound decisions. Had Gertrude sought professional counsel, she would have been assured that her estate would be administered efficiently, with minimized taxes and costs. After all, a little wisdom now saves a lot of trouble later—because, as they say, “an ounce of prevention is worth a pound of cure.”
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[i] https://www.coastalwealthmanagement24.com/estate-as-beneficiary-of-traditional-ira-or-retirement-plan/
[ii] ibid
[iii] https://www.lathropgpm.com/estate-planning-2024-federal-tax-update/
[iv] See https://www.thetaxadviser.com/issues/2021/mar/charitable-income-tax-deductions-trusts-estates.html for further discussion on this topic
