How to Leave an IRA to Your Heirs

By Blair Hodgson DuQuesnay

NEW YORK (AdviceIQ) -- Individual retirement accounts and qualified plans such as 401(k)s can be wonderful assets to leave to your heirs. But you need to do some extra planning to make sure the money goes to the right family members and minimize their tax bill.

Some folks are confused because IRAs and retirement plan assets pass to your heirs based on beneficiary forms and not by the instructions in your will. It's also hard to tell how long your beneficiaries may keep the money in the tax-deferred account.

If you plan to leave the assets to minor children, create a trust for them and name the trust as the beneficiary of the retirement account. Minor children are unable to legally accept an inheritance until they reach the age of majority, which is either 18 or 21 depending on your state.

In many cases, the court appoints a guardian for the minor and may even restrict the types of investments allowed in the inherited IRA. By creating the trust for the benefit of the child, you determine who has control and how the money eventually gets distributed to the child. Remember to list the trust, not the child, on the beneficiary form.

The required minimum distributions -- withdrawals from your retirement account you ordinarily must take at age 70.5 -- can be a problem with an inherited IRA, where you must begin pulling out money long before 70.5.

For multiple heirs in different generations, it's better to create separate trusts. If you use just one trust with multiple beneficiaries, RMDs are based on the oldest beneficiary's birthdate. Assume you name a trust for the benefit of your spouse, your son and your daughter for an IRA valued at $1 million; here are the annual required minimum distributions for each beneficiary based on their life expectancy:
  • Spouse (59): 26.1 years; $38,314 per year
  • Son (17): 66 years; $15,152 per year
  • Daughter (15): 67.9 years; $14,728 per year

But in this example, all three beneficiaries are required to share the maximum distribution of $38,314 per year. This is less desirable because it depletes the inherited IRA faster and results in higher taxes.

If you do not need the income from IRA or retirement plan assets, it might be best to convert to a Roth IRA now. You pay income tax on the converted amount upfront, but your heirs inherit a tax-free asset. They still are required to take minimum distributions, but when they withdraw money from the account they do not owe any income tax.

You can roll over small amounts of your IRA each year rather than convert to a Roth all at once. Heirs other than your spouse can't change an inherited IRA to a Roth IRA after your death. On the other hand, they can switch an inherited qualified plan such as a 401(k) to a Roth IRA. This may weigh upon your decision to roll over your retirement plan to an IRA.

If you name a charity as a beneficiary of your IRA or qualified plan, list the percentage of the amount you wish to leave the charity rather than a dollar amount. Failure to list a percentage amount leads to a no designated beneficiary status for the account. This means your remaining heirs are forced to withdraw funds from the IRA within five years rather than stretching distributions over their lives. The end result is that your heirs pay more in tax immediately.

Be careful if you're in a second marriage with children from both spouses. It's very easy to disinherit your children unintentionally by naming the second spouse as sole beneficiary of your IRA or retirement plan. In any situation involving children of multiple spouses, you need to do extra planning to ensure your estate plan is in order.

A good rule of thumb is to review all beneficiary forms once a year. Often we go through major life changes such as births, marriage, divorce or deaths without remembering to update the estate plan. There are countless horror stories of accidentally leaving an account to an ex-wife.

IRAs and retirement plans present great opportunities to leave tax-efficient assets to your heirs. But the beneficiary designation decision is often not that simple. It helps to consult a trusted financial adviser for help with estate planning and beneficiary designations.

-- By Blair Hodgson DuQuesnay, founder and CEO of Ignite Investments and Planning a registered investment advisor domiciled in the state of Louisiana. She posts financial insights regularly on her blog.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

AdviceIQ is a network of financial advisors that writes insightful articles for the public about investing and wealth management. All articles are edited by AdviceIQ's editor in chief, Larry Light. AdviceIQ certifies that all its advisors have no regulatory infractions.

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