It’s complicated. When deciding to name beneficiaries for your IRA, it may seem like the path of least resistance to name your estate. After all, your Last Will and Testament details all of your desires and will make sure your estate is distributed to the “right” people, right? Not so fast! If you are not properly informed, the IRS could turn out to be the “right” person.
There are a number of special rules regarding the inheritance of a traditional IRA that everyone should understand. The first one is that during your lifetime, IRA’s receive the benefit of tax deferral on all of the investments held inside the IRA. At death, the IRS laws dictate these assets need to be taxed. The question is how soon, how much, and at what rate will the IRA assets be subject to income taxes.
If you name your estate as beneficiary, all of the IRA assets will be distributed in one year to the estate. That means 100% of the IRA value will become taxable income in the estate. The alarming fact is that, when filing an estate tax return, the income tax rate jumps to 35% with just $11,650 of income. This is a very low threshold, considering the personal income tax rate of a married filing joint filer needs to be over $388,350, before a 35% income tax rate is reached. Keep in mind that the IRA distribution to the estate will be done in one year, catapulting income to perhaps extremely high levels.
So how can one eliminate this potential avalanche of income taxes? By naming individuals instead of your estate, you can significantly reduce the immediate tax bill. Individuals have the option of stretching out the IRA distributions over their lifetimes, so that only a portion of the assets will be taxed in one year. So think twice about naming your estate as your IRA beneficiary. Reach out to your estate attorney or financial planner to assist with maximizing your heir’s inheritance.