Why IRA Beneficiaries Should Name Their Own Beneficiaries

I just had a call from an advisor with a “complicated” scenario. “Ralph” died and left his IRA to his spouse “Alice.” Ralph was 62 in the year he died.

Alice did nothing with the IRA. It remained an inherited IRA and there were no required minimum distributions (RMDs) until the year Ralph would have been 70 ½. Alice did not name any beneficiaries.

Two years later Alice dies. She was 61 at the time of her death. Since there were no named beneficiaries, the IRA agreement said the default beneficiary was Alice’s estate.

Alice’s mother inherited the IRA through the estate. She named her four surviving children as the beneficiaries of her inherited IRA. Alice’s mother has now passed away and her inherited IRA has been split into four inherited IRAs for her children.

The question is how to calculate the RMDs on the four inherited IRAs.

The answer in this case is actually quite simple; but it is not the answer the beneficiaries had hoped for. At Alice’s death the IRA went to a non-designated beneficiary – one with no life expectancy – as her estate was her beneficiary. Since both Ralph and Alice died before they were required to take RMDs, there is only one distribution option for Alice’s beneficiaries. The five-year distribution rule is their only option. There is no stretch payment option.

Under the five-year payout rule the entire IRA balance must be distributed to the beneficiaries by the end of the fifth year after Alice’s death. There are no RMDs for years 1-4 after Alice’s death. The beneficiaries can take as much or as little as they want in those years. There is an RMD in year 5 which is the total account balance.  

If the IRA balance is relatively small, a five-year payout may not be a bad option for the beneficiaries. But if the IRA balance is large, then the beneficiaries end up with a huge tax bill for potentially five years.

There is one other consideration is this scenario. The funds in the IRA were earned by Ralph but they are being inherited in their entirety by Alice’s family. This may not be what Ralph really wanted.

The bottom line is that beneficiaries should be sure to name their own beneficiaries as soon as possible after they inherit a retirement account. If Alice had named her siblings as her beneficiaries they would have been able to stretch their inherited accounts out over their own ages instead of having to empty the accounts within a couple of years.