Ira Beneficiary Income Tax Planning

IRAs grow tax-deferred until you make a withdrawal. At the time of withdrawal, you are income taxed on the withdrawal. When you pass, beneficiaries are also income taxed when they withdraw from the IRA. Prior to the SECURE ACT (which became effective at the beginning of 2020), children who were beneficiaries could stretch an inherited IRA over their life expectancy. However, as a result of the SECURE ACT, the continued tax-deferred growth is only permitted for a (1) surviving spouse; (2) beneficiary that is less than 10 years age difference than the IRA owner who passed; (3) minor child of the IRA owner; (4) disabled beneficiary; or (5) beneficiary who is chronically ill. An individual beneficiary that fits within one of these five categories is considered an Eligible Designated Beneficiary (“EDB”).

Any individual who is not an EDB is a designated beneficiary. If one is a designated beneficiary (“DB”), then withdrawals must be made within the ten (10) years following the year of death of the IRA owner. In other words, the government wants you to save for retirement by giving the benefit of tax-deferred growth, but they don’t want to make your children rich as the government wants its tax dollars quicker than in the past. As a result, the following are a few things to consider in making your beneficiary designations.

1. IF YOUR IRA IS NOT LARGE AND YOU ARE SURVIVED BY YOUR SPOUSE, THEN CONSIDER A SPOUSAL ROLLOVER

Under Texas law, you typically are required to name your spouse as beneficiary unless the spouse consents to not being named as the beneficiary. Surviving spouses typically roll over the IRA for continued tax-deferred growth.

2. IF YOUR IRA IS LARGE, DETERMINE IF YOUR SPOUSE NEEDS THE INCOME (CONSIDER DISCLAIMER PLANNING)

If your spouse doesn’t need all the income that he or she would have received from a spousal rollover (and perhaps the children do), either the surviving spouse could elect to disclaim all or part of the IRA (within nine months assuming the surviving spouse hasn’t already elected to do a rollover) or you can name the surviving spouse and the children according to percentages desired assuming your spouse permits this. If the children do not withdraw the IRA all at once, then there is a likelihood that the income would be taxed at a lower rate. For example, the child could take 1/10 each year and possibly be taxed at a 22% bracket instead of the highest income tax bracket of 39.6%.
 

3. IF YOU HAVE A DISABLED CHILD, CONSIDER A HIGHER PERCENTAGE TO THE DISABLED CHILD THAN TO A CHILD THAT IS NOT DISABLED

Since a disabled child is one of the exceptions permitting tax-deferred growth, many consider giving more of the IRA to the disabled child or to a special needs trust for the benefit of the disabled child. However, if a special needs trust is a beneficiary and the disabled beneficiary is receiving Medicaid which requires limited income, then a provision to accumulate the IRA distribution retaining the income inside the trust should be considered to reduce use of loss of Medicaid eligibility.

4. IF YOU HAVE A LARGE IRA AND YOU WANT TO STRETCH THE IRA DISTRIBUTIONS FOR CHILDREN AND YOU ARE CHARITABLE

If you have a large IRA, your children may get more over their lifetime by naming a charitable remainder trust as a beneficiary of your IRA. The children could get annual income from the trust for life and the charity would receive the remainder after their death.

5. IF YOU ARE CONCERNED THAT YOUR BENEFICIARY WILL FAIL TO CONSIDER BOTH TAXES AND GROWTH, THEN NAME A TRUST

The SECURE ACT, does not require a designated beneficiary (those who are not an EDB) to take out annually. So, for example, some children might wait until the 10th year following the year of death to have maximum tax-deferred growth. Other children might want the money immediately and pay the tax immediately. In either of those events, there would be a large income tax. If the IRA owner is concerned about that, then the IRA can name a trust as the beneficiary and state that the beneficiary receives 1/10 of the IRA annually to possibly lower taxes and maintain some tax-deferred growth. However, if income in the trust that is not distributed is too high, then there could be a higher income tax rate on the income that is not distributed to the child.

6. IF A CHARITY IS A DIRECT BENEFICIARY, THEN THERE IS NO INCOME TAX ON THE WITHDRAWAL

Depending on the year of your birth, you are required to make minimum distributions after you are 70½ or 72. Some IRA owners do need the income or are charitable or both. Instead of being income taxed on the withdrawal, the IRA owner can request a direct distribution to a charity or charities (up to $100,000 in a year) without taxation.

If interested in learning more about this article or other estate planning, Medicaid and public benefits planning, probate, etc., attend one of our free upcoming virtual Estate Planning Essentials workshops by clicking here or calling 214-720-0102. We make it simple to attend and it is without obligation.

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