Estate planning tips: What happens to an IRA on death of owner?

Clients often ask, “What happens to an IRA on the death of the owner?” The answer, of course, is, “It depends.” IRAs are typically outside of your estate planning documents in that we do not fund IRAs to your revocable trust. The IRA is like a contract that you have with the financial institution, such as Fidelity or T. Rowe Price, that holds the IRA for you. In the contract, you designate a beneficiary who will receive the IRA on your death. Therefore, the IRA does not have to go through probate and it does not have to be transferred to your trust. The financial institution will transfer the IRA to your beneficiary once he proves that you have died.

The potential problems that arise when an IRA owner dies fall into two categories. In the first category are IRAs that actually do not have a beneficiary designated. This can happen if you designate someone when you establish the IRA but that person dies before you do and you never changed the beneficiary. What happens then is your estate becomes the default beneficiary. Now the IRA will have to go through probate.

In addition, an estate is not an individual and is therefore not a “designated beneficiary” according to the Internal Revenue Code. When someone other than a “designated beneficiary” inherits an IRA, the assets in the IRA must be distributed out within five years, and remember, when assets get distributed out of an IRA the recipient pays income tax.

If instead, the “designated beneficiary” is the surviving spouse of the IRA owner, the spouse can simply roll that IRA over into his or her own IRA and it will be treated for all purposes as the surviving spouse’s IRA, meaning the surviving spouse does not have to take required minimum distributions (RMDs) until he or she is 70 ½ years old, and the amounts of the RMDs are calculated on the basis of the surviving spouse’s life expectancy, not the deceased owner’s. If the “designated beneficiary” is not the surviving spouse, he will have to begin taking RMDs generally within about a year of the death, and the RMDs may be calculated on the basis of the deceased owner’s life expectancy in the year of his death.

The other category of potential problems arises when the “designated beneficiary” goes to the financial institution to claim his inheritance. If he is not careful to specify that he wants to create an inherited IRA, the financial institution may simply cut a check payable to the heir. Once that happens, unless the heir is the surviving spouse, income tax will be payable on the whole amount and the opportunity for stretching out the tax-deferred status of that IRA is gone. These inherited IRAs must be handled by means of a “trustee to trustee transfer,” in other words, the heir cannot receive the IRA, even for a moment. Surviving spouses, however, can take the IRA check directly and they get 60 days to roll it into their own IRA.

Kirsten Howe practices estate planning law in Walnut Creek. Send your estate planning questions to Kirsten by e-mail.

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Comments

  1. Don Owens says

    All of the descedent’s assets are distributable to a non-profit university by will. What are the procedures for transferring an IRA account?