When it comes to IRA inheritance and beneficiary designations, a self-directed IRA is treated the same as any other IRA.
Choosing who to name as beneficiaries for your IRA and how to make your designations can be simple or complex, depending on your situation and goals.
Rules around how a non-spouse beneficiary treats an IRA inherited after December 31st, 2019 changed due to the SECURE Act. These changes merit consideration if you have not reviewed your account beneficiaries in some time.
The best practice is to speak with your licensed estate planning counsel about IRA beneficiary designations. Following are some tips to help guide that conversation.
When are Beneficiaries Designated?
You are required to name at least one primary beneficiary when you setup an IRA account. You can choose to make additional designations during the account setup or wait until after the account setup is complete.
You can add or change IRA beneficiary designations at any time, usually by submitting a simple form to the IRA custodian.
Primary and Contingent Beneficiaries
Beneficiaries come in two classes: primary and contingent. A primary beneficiary will inherit their allocated share of the IRA at your passing. If no primary beneficiary is available, then the contingent beneficiary designation will be applied.
When you designate beneficiaries, you must allocate 100% primary beneficial interest. You can designate one or more beneficiaries as primary, so long as the allocation adds up to 100%.
Naming contingent beneficiaries is optional. If you name any contingent beneficiaries, you must allocate 100% of the account value across the named parties.
Naming Your Spouse
Most married IRA account holders choose to name their spouse as the primary beneficiary for their IRA. A spousal inheritor has the most flexibility and control.
They can either just move the existing account into their name or roll the IRA into another IRA or 401(k) in their name. The funds in the IRA are treated as theirs, and subject to all the same rules and timelines for distributions as if the account was initially opened in their name.
Alternately, a spouse can choose to be treated as a beneficiary. This will allow the spouse to take distributions from the account without a 10% penalty for early distribution if they are under age 59 ½. This beneficiary election will mean the account is subject to Required Minimum Distributions using the spouse’s life expectancy table. A beneficiary IRA of this type cannot be consolidated with other retirement plans in the spouse’s name.
Naming a Non-Spouse
You can name any individual or entity as an IRA beneficiary. Depending on your marital status, family structure, and goals, you might choose to name one of more of the following:
- A Trust
- Charitable organizations
- Educational institutions
The timeline for distributions and how the distributions are taxed will vary based on the type of beneficiary.
Community Property States
If you are married and live in a community property state, you must obtain your spouse’s written consent if you wish to name someone other than your spouse to receive any fraction of the primary beneficial share.
Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Naming a Trust
Naming a trust as beneficiary for your IRA can have several advantages.
If you have beneficiaries who are minors or otherwise unable to care for themselves, using a trust is a good way to ensure they are cared for based on your instructions.
With a trust, you can continue to control who contingent beneficiaries are. If you were to directly name a second spouse as your beneficiary, they could change the designations on the account once they inherit it and cut out children from a first marriage you may wish to include, for example. A properly implemented trust will eliminate such a situation.
Taxation can flow to the receiving beneficiary or occur at the trust level depending on how things are configured.
Utilizing a trust effectively is complex. Be sure to seek qualified counsel if you choose to name a trust.
If you have a trust named as beneficiary on your IRA, it would be a good idea to ensure it is compatible with the changes created by the SECURE Act.
Distribution Rules for Different Beneficiary Types
Who you name as beneficiary can determine how quickly the account needs to be distributed.
A non-named beneficiary such as an estate, charity, or trust that does not specifically name individual beneficiaries will need to distribute the entire IRA within a 5-year period if the account holder was under the age of 72 when they passed. If the IRA owner was over age 72, then the life expectancy table of the owner is used to determine the required minimum distribution amount each year.
An “Eligible Designated Beneficiary” will be able to distribute the account over time. The longer of the beneficiary’s or the account holder’s life expectancy table will be used to determine the minimum required distribution each year. Eligible Designated Beneficiaries include:
- The owner’s spouse
- Owner’s children under the age of 18, though they must then fully distribute the IRA by the age of 28 – ten years from reaching majority.
- A disabled or chronically ill individual
- Any other individual who is not more than 10 years younger than the original IRA owner
A designated beneficiary who is not in the list of Eligible beneficiaries must distribute the account in full by the end of the 10th year following the IRA account holder’s death.
Keep Your Designations Current
It is important to regularly review your IRA beneficiary designations and make updates as appropriate. We recommend you perform a mid-year financial review in the summer when financial and tax issues are usually quiet and include an IRA beneficiary check as part of this process.
Make Sure your Beneficiaries Know about your Self-Directed IRA
One of the unique things about a self-directed IRA is that there is not a statement with a list of publicly traded assets that an inheritor can easily look up.
It is therefore important that you keep records of your plan holdings in a place known to the person who you have chosen to administer your affairs.