Traditional IRAs are subject to a unique set of complex rules. Whether you’re drafting a will or preparing to inherit an IRA, it’s helpful to have a high-level understanding of what it means to pass on (or receive) this type of account.
Here, we’ll look at six significant differences between IRAs and other types of accounts that commonly factor into estate plans.
IRAs don’t typically pass through your will.
Unless you designate your estate to be the beneficiary of your IRA, it will not pass through your will. The accounts will have a designated beneficiary. The designated beneficiary is the person who receives the IRA upon your passing, regardless of what your will or living trust states.
IRAs aren’t typically subject to probate.
Again, if the account passes to a beneficiary and not an estate, probate isn’t required. This can significantly save time and money, especially in states where probate is complex.
IRAs don’t receive capital gains treatment.
Any distributions from an IRA are taxed as ordinary income and not at the lower capital gains rate.
IRAs don’t receive a step-up in cost basis upon death.
Most other assets in accounts owned by an individual receive a step-up in cost basis upon the person’s death, eliminating all capital gains on the assets up to that point in time. But not IRAs. If the beneficiary of your IRA is an individual, any distribution to that person will be taxed at his or her ordinary income tax rate. If you name a qualified charity as your beneficiary, however, the funds will be transferred tax-free.
In most cases, IRAs can’t be gifted.
If you want to give some of your IRA to an individual or organization, you must first take a distribution, pay the income tax and any applicable penalties, and then make the gift. There is an exception to this rule, known as the Qualified Charitable Distribution (QCD), for individuals over the age of 70½ giving $108,000 or less to a qualified charity. If all criteria are met for the QCD, then the distribution is excluded from your taxable income.
Traditional IRAs are subject to Required Minimum Distributions (RMDs).
The IRS has designed IRAs so they can grow deferred for many years. However, starting the year you turn 73 (for those born in 1951–1959) or 75 (for those born after 1960), you are required to distribute, or withdraw, a portion of your IRA.* These RMDs continue annually. For beneficiaries, the withdrawal rules depend on their beneficiary category: non-designated, eligible designated, or non-eligible designated (see these categories here).
*For your first RMD only, you have until April 1st of the following year to withdraw that RMD. If you choose to delay your RMD, you will have two RMDs to withdraw that year. After the first year, RMDs must be completed before the end of the calendar year.
If you own a traditional IRA, you may be able to reduce the amount of taxes paid on the account in your lifetime (and after), but it requires strategic planning. Reach out to your adviser to define your goals, evaluate your tax strategy, and review the role your IRA plays in your estate plan.
Originally Posted: June 17, 2020
