Understanding IRA Beneficiaries

What is a beneficiary? For IRAs, the IRS defines a beneficiary as the person or entity who is chosen to receive the IRA funds when the original account holder passes away. Investors can choose both a primary and contingent beneficiary for each IRA account. The primary beneficiary receives all of the IRA funds upon the account owner’s death. But if the primary beneficiary dies first (or decides to disclaim the funds), the IRA will automatically pass to the contingent beneficiary, if one is listed.

Investors are often prompted to choose and update both their primary and contingent beneficiaries. Otherwise they lose control over who would receive those funds. It could go to a default beneficiary, oftentimes the account owner’s spouse. But it could also go directly to the individual’s estate. That can drag the account into the probate process, which proves that a will is legally valid, and can easily last several months to a year, assuming there is no conflict. It could last even longer.

One of the primary benefits of opening an IRA is that it can avoid the probate process entirely, including costly fees assessed on the estate’s assets. But when an investor declines to choose a beneficiary, they automatically forego those benefits. And if a spouse anticipates using those funds as a beneficiary retirement plan, they could be without those funds for a long time while waiting for the probate period to end.

According to the IRS, IRA account owners may choose any individual or entity to be a beneficiary. In states with community property laws, however, a spouse may supersede any named beneficiaries.

In addition to naming a primary and contingent (or secondary) beneficiary, account owners can also name multiple beneficiaries. They can split up the funds either by percentages or by fixed dollar amounts. Each beneficiary doesn’t have to receive equal portions; the account owner can divide up the IRA however they see fit.

There are two types of IRA beneficiaries, each of which has their own set of distribution rules. 

Spouses

When inheriting an IRA, spouses have two options. The first is to roll some or all of the funds into their own IRA within 60 days of receiving the distribution. With this strategy, the required minimum distributions (RMDs) are calculated using the spouse’s age. So if they’re younger than 72, they can delay withdrawing funds. 

The other option spouses have is to structure the IRA as an inherited IRA. These RMDs depend on the original account owner:

• If they were already taking RMDs, the spouse must continue taking these withdrawals based on their own life expectancy.
• If they hadn’t started taking out RMDs yet, the spouse has five years until they’re required to withdraw the funds. With a traditional IRA, that money would be subject to income tax. 

Non-spouses

Non-spouses have fewer options for an inherited IRA. Rather than rolling over funds into their own IRA or taking a distribution within five years, they must do one of the following: 

• Open a new inherited IRA account. In most cases, the funds must be cashed out within 10 years.
• Take a lump-sum distribution.

There are many rules for beneficiaries who receive an inherited IRA. 

Final RMD for the deceased

One important detail for beneficiaries to understand is that if the account owner was required to take an RMD in the year they died, but hadn’t taken that distribution yet, the beneficiary must do so before the end of the year. 

Estate tax deduction

While IRAs are exempt from the probate process, they may be subject to estate tax. But the beneficiary can take a tax deduction on these costs when they file their personal income tax returns.