Upon a person’s death, their estate is generally distributed according to the terms set forth in their will (assuming they have a legally recognized will). IRAs, however, aren’t distributed according to the the dictates of a will. Here’s what you need to know about how the assets in IRAs are distributed, so you can ensure yours will be distributed according to your wishes if you pass away.
IRAs Aren’t Considered Part of Estates
IRAs are retirement accounts and, as such, aren’t considered to be part of people’s estates. IRAs don’t have to go through probate, which is why the distribution of their assets upon the account holder’s death isn’t governed by a will. Instead, the assets in an IRA are distributed according to (in order of priority):
- the laws of the state where the account holder was a resident
- any named beneficiaries that are listed on the account
- the custodian policy of the account holder’s IRA
State Laws That Govern IRA Distributions
First and foremost, state laws govern the distribution of an IRA’s assets. As there are 50 states, there are 50 different versions of laws that determine how IRAs are distributed. In general, though, states’ laws can be categorized into two categories.
While all states have laws that govern the distribution of IRAs, the vast majority of states’ laws don’t significantly interfere with how the assets in these accounts are dispersed upon the account holder’s passing. In 40 states, IRAs are distributed according to either their named beneficiaries or custodian policies.
There are 10 marital or communal property states: Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wyoming. In these states, the assets in an IRA can’t be passed onto anyone other than the account holder’s spouse, unless the spouse has given explicit, written permission to give the IRA’s assets to another person or an organization. For example, an account holder in these states can’t pass on the assets in their IRA to their children unless their spouse has written that it’s alright to do so. In Texas, which has the most stringent marital or communal property laws, account holders even need to have permission from ex-spouses if they want their IRA to go to someone other than their former spouse (Holmes v. Kent, 221 S.W.3d 622 (Tex. 2007)). With written permission, even in Texas, account holders can pass their IRAs onto anyone they like.
Named Beneficiaries and Custodian Policies Govern Distributions
Unless communal or marital property laws dictate otherwise, IRAs are typically distributed to the people and entities that are named as beneficiaries of these accounts. Account holders are able to name beneficiaries when setting up their account, and the beneficiaries can be changed at any point in time. Usually, the company that administers the IRA keeps a paper that states who the account’s named beneficiaries are on file.
If there aren’t any named beneficiaries to give an account to, then it will be distributed according to its custodian policy. This can happen if an account holder decides not to (or forgets to) name beneficiaries, or if the named beneficiaries pass away before the account holder. The custodian policy is a policy that the company managing the IRA has. The policy sets forth standard operating procedures, including how to disburse assets if there aren’t any named beneficiaries when the account holder passes away.
While many custodian policies give assets first to a spouse, and then to either children or the next-closest kin, these policies’ may not always be in line with the account holder’s desires. Therefore, it’s important to name beneficiaries for your retirement account. Not only should you name beneficiaries when setting up the account, but you should also review your accounts named beneficiaries anytime you go through a significant life change, including:
- moving to or from a marital or communal property state
- getting married or divorced
- having children
- welcoming new grandchildren
If you only update your will, but not your IRA’s named beneficiaries, your IRA may not be distributed how you’d like should you pass away.
Advantages and Disadvantages of Certain Named Beneficiaries
When naming beneficiaries, you have several options. Individuals, organizations, trusts, and your estate can all be named as a beneficiary of your IRA. Each of these has advantages and disadvantages.
The simplest solution is to name the people or organizations that you want your IRA to go to as beneficiaries. This takes only a moment to do, usually requiring nothing more than filling out a single form. You can choose any individuals or organizations you’d like, and you can determine what portion of your IRA each will receive (they don’t necessarily need to be equal).
Should you choose to name people or organizations, be aware that they will be able to spend the assets they receive from your IRA any way they choose and as soon as they choose. Even young children will have uninhibited access to the assets they inherit from your IRA if you choose to list them as named beneficiaries.
If you choose to name your estate as the beneficiary of your IRA, then the IRA will ultimately be distributed according to the terms in your will. It’ll first become part of your estate, and then it’ll go through probate.
Naming your estate as a beneficiary, however, has a significant tax disadvantage. If you’re under the age of 70½ (at which point you must begin mandatory withdrawals), the heirs of your estate will need to withdraw all of your IRA’s assets within 5 years. If you’re over 70½, they’ll need to withdraw funds according to your age when you pass away. In either case, the heirs that receive your IRA’s assets won’t be able to significantly delay withdrawing from your IRA if you make it part of your estate. This could prevent them from taking advantage of the tax benefits that an IRA affords.
Naming trusts as beneficiaries has many advantages. They let you control when your heirs can access the assets in your IRA, and they let your heirs delay withdrawals if it’s advantageous for them to do so. You can also use trusts to stipulate (to a degree) how the funds on your IRA are used and to shield your IRA from creditors.
Creating a trust that meets the IRS’ requirements and stands up under legal scrutiny, however, is an intricate process. It’s best to hire a lawyer who is familiar with trusts if you want to take advantage of the benefits that they offer.
Name Beneficiaries for Your IRA
No matter who you want to name as beneficiaries, make sure you have beneficiaries named for your IRA. It’s the only way to make sure your IRA will be distributed to others the way you’d like it to be.