As far off as retirement might seem, death probably seems even farther. However, if you're storing away money in your individual retirement account, you should name a beneficiary for your IRA. When someone dies without a beneficiary named for his IRA, the money gets paid out to his estate, which is just about the last place that you want your IRA going after you die.
Limited Distribution Period
When the IRA goes to your estate and you haven't started required minimum distributions, the IRS requires that all the money be cashed out by the end of the fifth year after your death. That means you're cutting the tax-sheltered growth of the plan woefully shorter than a beneficiary could have stretched it out if you had named one. Plus, if you had named your spouse as the beneficiary, your spouse could have combined it with an IRA in her own name.
Taxable to Estate
It sounds strange, but when the money is paid to the estate from the IRA, the IRS expects the estate to file an income tax return -- which is separate from the federal estate tax return. When the money gets cashed out of the IRA, the IRS still expects any applicable income taxes to be paid even if the estate is the recipient. If the money gets paid out within the same tax year, the estate can take a deduction for that portion of the IRA distribution and the beneficiary must include the money in his income. For example, say the estate cashes out a fully taxable $100,000 IRA and distributes $30,000 to a beneficiary within the year. The estate reports $100,000 of income and $30,000 of distributions, for a net of $70,000 of taxable income. The beneficiary reports $30,000 of income.
Taxability of Distribution
When the estate takes distributions from the IRA, the distributions are taxable to the same extent they would have been if they were paid directly to an individual. For traditional IRAs, that means the entire withdrawal is taxable unless the decedent had made nondeductible contributions. If so, the distribution is split proportionally between the tax-free nondeductible contributions and the taxable remainder of the IRA. For Roth IRAs, the entire withdrawal is tax-free if the it's been open for at least five years. If not, the contributions come out tax-free first, but then the earnings are counted as taxable income.
Limited Surviving Spouse Exception
When the IRA doesn't name a beneficiary, the IRS has held in a private letter ruling that the surviving spouse can't elect to treat the IRA has her own because it passed through the estate rather than going directly to her. In addition, the general rule is that even a surviving spouse who receives payments from the estate isn't allowed to roll over the distribution into his own IRA because the payment comes from the estate, not directly from the IRA. However, the IRS makes an exception if "the surviving spouse is the sole personal representative of the decedent's estate who must pay the decedent's IRA to himself as sole intestate beneficiary of the estate, and who, after such payment rolls them into an IRA set up and maintained in her name." If that's the case, the portion paid to the surviving spouse can be rolled into one of her own IRAs within 60 days without taxes or penalties to maintain the tax-sheltered growth.
- Internal Revenue Service: Publication 590 -- Individual Retiement Arrangements (IRAs)
- CNN Money: Pick Your IRA Beneficiary
- Motley Fool: Designating IRA Beneficiaries
- Smart Money: Closing Down the Estate
- Internal Revenue Service: Form 1041 Instructions
- Internal Revenue Service: Private Letter Ruling 200324059
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