It is one of the most common IRA mistakes, and one of the most costly: naming just one of your children as the beneficiary of your IRA. Some treat the IRA just like they would a will, choosing one child as the ‘executor’, ‘so that child can simply divide up the funds’. However, due to the specific tax attributes of IRA’s this approach can result in tens of thousands, and in some cases hundreds of thousands in extra taxes. It is far better to name each of the beneficiaries that you would like to receive funds.
As a quick background, remember that the tax code allows you to name specific beneficiaries for an IRA account. Upon the death of the IRA owner, by law, the funds will pass to the beneficiaries named in the document. The IRA document itself will control who inherits the funds, not the owner’s will or trust. Most name a spouse as the primary beneficiary and then children as the contingent beneficiaries. When each beneficiary is named properly it is actually a quick easy way to direct your money to the individuals you choose.
The problem occurs when you try to shortcut the process and name just one beneficiary when your intent is to divide the funds between several. The IRS does not allow the sole beneficiary to divide the IRA. As a result, the sole beneficiary will be required to distribute the funds from the IRA, and pay the resulting taxes, in order to divide up the funds.
Consider the following example: You have 4 children but decide that it would be easiest to name the oldest as the beneficiary of your $1 million IRA and ask him to divide the inheritance between his siblings. Your oldest will inherit a $1 million IRA, but knows that he is supposed to only keep $250,000, sharing the $750,000 balance with his siblings. In order to fulfill your wishes, your oldest will be forced to first distribute the $750,000 from the IRA to himself, paying taxes at the highest rate (probably close to 50%), and then send the funds to his siblings. The result is an approximate $325,000 tax burden.
When each child is named as the beneficiary of the IRA, the IRA itself is simply divided, and each child inherits the funds in its pre-tax state. In the example above, each of the four children would simply inherit a $250,000 IRA and, except for relatively minor required minimum distributions, the funds would remain tax-deferred. Each child would have the option to decide when and if to distribute the funds and would be able to make better use of the lower tax brackets.
If you haven’t reviewed your beneficiaries in a while, take some time to consider who you would like to name to inherit your IRA assets. For many, naming IRA beneficiaries is one of the most important, and easiest steps in the estate planning process.