This 1 Form Keeps the IRS’ Hands Off Your Heirs’ Money

Who gets what when someone dies — and how?

It should be simple, right?

A person has a will, and that does the job. Or they don’t, and a probate court decides.

You’d think so. But it’s more complicated than that.

We’re free to leave our possessions and assets to whomever we wish. But there’s one claimant who gets something from many of us whether we want it or not.

The IRS. The other part of the old “death and taxes” saw.

And if you don’t plan properly, the taxman will get more than he should … leaving your heirs with less.

You didn’t work your whole life to provide for the spendthrifts in Washington … so don’t let them take more from your true heirs than they should.

The IRA 2-Step

Individual retirement arrangements (IRAs) are dual-purpose vehicles.

We normally think of them as tax-advantaged retirement savings. But they are also an ideal way to leave money to your heirs.

It’s simple to leave an IRA to your spouse or children. Inheriting one is the complicated part. It’s critical that you and your heirs understand the IRS rules to minimize the tax burden.

The rules governing inheritance of IRAs are different for spouses and nonspouses, like your children or grandchildren. But they have one thing in common: An IRA isn’t part of your estate. It passes directly to the beneficiaries.

That means your will doesn’t determine who gets your IRA. Instead, you must make that choice separately, on a “beneficiary form” provided by your IRA custodian. No matter what your will may say, that form determines who gets what.

So if you plan to leave IRA money to your heirs, it’s critical that you name them on the account’s beneficiary form, in the order of your preference. There are two reasons for that.

First, for nonspouse IRA heirs, being named on the form allows them to stretch out distributions from the IRA over their own lifetimes. That allows them to take small distributions every year. That way they don’t jump into a higher tax bracket.

But if you don’t list any beneficiaries by name, the IRA distributions can’t be stretched out, and the tax shelter is lost. Your heirs will have to pay tax on the entire distribution. Nearly 40% of an IRA could be lost to taxes if the heir cashes it out in one go.

Second, if your first choice of beneficiary dies before you or doesn’t want to take the IRA, listing other beneficiaries in order creates a sequence of “contingent beneficiaries.”

Easy for the Spouse, But…

A surviving spouse can choose to take an inherited IRA as their own or remain a beneficiary. But for nonspouse beneficiaries like a child, the rules are very different.

First, a nonspouse beneficiary must rename the account to include both the beneficiary’s name and the decedent’s name. For example, the account could be renamed as “Joe Bloggs (deceased March 1, 2018) for the benefit of Mary Bloggs.”

Second, a nonspouse heir can’t roll the money into their own IRA. Instead, required minimum distributions must be taken by December 31 each year, starting in the year after the original owner died. Your beneficiaries won’t pay an early-withdrawal penalty on the distributions, but they will pay income tax on required minimum distributions (RMDs) from inherited traditional IRAs. (Roths are tax-free.) If an heir misses an RMD, they will be hit with a 50% penalty for each year missed.

Finally, if your heir — say, your child — decides to pass on the IRA to one of your grandchildren, they can only do so if your original beneficiary form lists those grandchildren as contingent beneficiaries.

1 Form to Rule Them All

Whatever you do, don’t forget to update the IRS beneficiary form if your life changes.

If you divorce and never update your form to remove your ex-wife’s name as the sole primary beneficiary, she will get the money at your death even if your will says the money should go to your new spouse.

And if your children produce grandkids, adding them as contingent beneficiaries will allow your kids to pass on your IRA to them. That’s another reason to keep that form up to date.

The humble IRA beneficiary form appears as one piece of paperwork among many when you establish an IRA for the first time. As you can see, it’s anything but … so take your time, follow the rules and keep your money in the family … and out of the clutches of the IRS.

Kind regards,

Ted Bauman

Editor, The Bauman Letter

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This is a very interesting topic. The article is great, but there is one area where it is not quite correct. The article says “if your heir — say, your child — decides to pass on the IRA to one of your grandchildren, they can only do so if your original beneficiary form lists those grandchildren as contingent beneficiaries.” This is not actually how it works. Your heir must complete a beneficiary form of his or her own to pass on the IRA to his or her choice of beneficiary. After the original owner of an IRA passes away and the IRA is given to a beneficiary who survives him or her, the contingent beneficiary designations of the original owner become totally irrelevant. For this reason, any person who inherits an IRA should promptly complete a new beneficiary form of their own.

If the heir of an IRA does not make a beneficiary designation, the account will be given to the estate of the heir upon his or her passing, according to the rules of the IRA plan. The default rule of most IRA plans is to have the account given to the estate of the current owner when no beneficiary has been named. But the consequences of having an IRA given to an estate are very unfavorable to the ultimate heirs of the estate. This is why any heir of an IRA should promptly designate new beneficiaries.

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