Should I Name My Estate as the Beneficiary of my IRA?

A client was confused. He knew that the federal estate tax only applied to estates in excess of $11 million, so he didn’t understand why significant taxes were due on an IRA he inherited from a relative who did not have a large estate.

After discussing the matter with him, I discovered that his relative made a crucial mistake. Instead of naming my client as the beneficiary of his traditional IRA, he named “My Estate.”

Traditional IRAs are tax deferred assets. You can deduct contributions to an IRA on your tax returns and earnings grow tax free until you withdraw the funds.  Since taxes are deferred, income taxes are due each time funds are withdrawn.

When you name an individual (or a trust that qualifies as a designated beneficiary) as the beneficiary of a traditional IRA, the beneficiary can choose to take only required minimum distributions over the course of his or her life expectancy. This allows for more tax-deferred growth and minimizes the amount of income tax that is due when withdrawals are made.

However, if you name “My Estate” or you forget to name a beneficiary at all, and you die before April 1 of the year you turn 70 ½, your IRA will need to pay out all the funds to the estate within five years (or according to your life expectancy if you die after 70 ½). This limits the opportunity for tax deferred growth and exposes the funds to potentially significant income taxes.

With the estate tax exemption currently so high, income tax is a greater concern. Making appropriate beneficiary designations is an extremely important part of any estate plan. If you have an IRA, make sure you have named a primary beneficiary and an alternate beneficiary.

But make sure you don’t name your estate as either.