IRS Rules for Transferring an IRA Held by an Estate to a Beneficiary
It is impossible for an estate to own an individual retirement account. These are personal retirement savings vehicles granted tax-deferred status and highly regulated by the Internal Revenue Service. While the estate can't own the IRA, it can receive the IRA assets once the IRA owner dies. There are specific rules for distributing IRA assets depending on how the beneficiary designations are listed.
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Avoiding Probate
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An IRA bypasses the probate process as long as a person or persons are named as the beneficiary. This means children, grandchildren, siblings and even the neighbor have quick access to money upon the IRA owner's death as long as they are the named beneficiary. The IRA beneficiary designations supersede any last will and testament or family trust. The IRA custodian is required to distribute the assets according to the written elected options provided by the beneficiary along with the death certificate. Naming an "estate" as the beneficiary puts the IRA in the probate estate.
Estate as Beneficiary
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When the estate is named as the beneficiary, the entire IRA not only gets dragged into the probate process, but the options to beneficiaries are eliminated. Living beneficiaries have the option to stretch IRA distributions over five years or roll the inherited IRA into a beneficiary IRA to further reduce distribution requirements. Reducing distribution requirements lowers income tax issues and allows continued tax-deferred growth of the inherited assets. The only option an estate has is to take a lump-sum distribution, with the entire amount added to the estate's income.
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Distribution of Assets
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Once the money goes into the probate estate, the estate executor must use the assets in paying off all debts and taxes left in the estate before distributing the assets to the listed beneficiaries. This is why avoiding probate is so powerful. If the beneficiary had the option to avoid the probate process, he could claim his inheritance without creditor's demands on the money. For example, if John inherited his grandfather's IRA, he could roll it over into a beneficiary IRA and use the money for college tuition expenses without any penalties. The IRA is preserved for that use rather than being lost to pay debts.
The Overall Inheritance
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The 2011 federal estate transfer tax rate is 35 percent for any estate over $5 million. No transfer tax is owed on smaller estates. The IRA, regardless of whether it is put in the probate estate, is counted toward the taxable estate. The top income tax bracket is also 35 percent. This means that 70 percent of an inherited IRA in larger estates might be immediately lost by allowing it to go directly into the probate estate. State transfer tax and income taxes vary and might add to the overall reduction of the IRA. Ultimately, leaving IRA assets to a person provides many more opportunities to preserve a lifetime of savings.
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