IRA Beneficiary Tax Consequences
Individual retirement accounts (IRAs) give you a valuable opportunity to save money for retirement while incurring a minimal tax burden. But as this savings often constitutes a large portion of a retiree's net worth, it's important to think about what will happen to the money after you die. With a little planning, you can make sure your legacy will help support your loved ones, rather than your creditors or the Internal Revenue Service (IRS).
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Naming a Beneficiary
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You can and should name an IRA beneficiary, and perhaps even a secondary beneficiary, who will inherit the account after your death. If you do not, IRA funds will pass to your estate--and the money will be fair game for creditors and the IRS. If the IRA passes to a beneficiary, however, it is exempt from estate law; and whomever inherits the funds can continue to take advantage of the IRA's tax-exempt status.
RMD Rules
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One of the many benefits of Roth IRAs is that you are not required to take distributions in your lifetime, unlike traditional, simplified employee pension (SEP) or savings incentive match plan for employees (SIMPLE) IRAs. However, any beneficiaries of Roth, traditional, SEP or SIMPLE IRAs are subject to the IRS's required minimum distributions (RMDs) if they wish to continue deferring taxes--otherwise, they are slapped with a 50 percent tax penalty. The IRS calculates a beneficiary's RMD by determining the beneficiary's life expectancy as of December 31 in the year of your death.
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Non-Spouses as Beneficiaries
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When non-spouses inherit an IRA, they can either take the money in a lump sum and pay taxes on it, or roll it over into an inherited IRA account where the funds are subject to RMDs. If they choose to roll over the IRA into an inherited IRA, they must take RMDs and cannot make contributions. They cannot keep the funds in the original account or roll the funds into their own IRA account.
Spouses as Beneficiaries
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Spouses who inherit IRAs can treat them as their own by simply transferring the account into their name and letting the money accumulate until they are subject to RMDs. If they want to withdrawal the money early, they also have the option of opening an inherited IRA.
Designating a Minor
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If you choose to make a minor your IRA beneficiary, the IRS will expect him or her to live for many years, and thus the RMD would be relatively low. This is great, as more money would be left in the account to accumulate tax-free earnings. An IRA also gives the beneficiary the freedom to take distributions for any reason without penalty. The downside is that the IRA funds would be entrusted to a guardian until the beneficiary reaches majority--if you fail to pick a guardian yourself, a court will likely decide after your death.
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