Individual Retirement Accounts (or IRAs) are financial accounts that allow an individual to invest funds now, take a deduction, and defer payment of income tax on the growth of those funds until a later date when you withdraw the funds (or in the case of Roth IRAs, the contributed funds continue to grow tax-free).
This favorable tax treatment was allowed by the IRS to incentivize saving for retirement. Many of us are familiar with how an IRA works while we are alive, but what happens to your IRA when you pass away? The answer to this question depends on who is named as beneficiary of your IRA.
If your spouse is the named beneficiary of your IRA, he/she may “roll it over” and treat your IRA as his/her own. This means that the required minimum distributions are determined based upon your surviving spouse’s age and he/she does not have to take distributions until he/she reaches age 70 ½ , allowing your spouse continued tax-deferred growth until they begin to take distributions.
If you name a non-spouse beneficiary, your beneficiary can stretch distributions over his/her life expectancy (based upon federal tables), but he/she must start taking distributions in the year following the date of death. It should be noted, however that President Obama has proposed eliminating these “beneficiary IRAs” or “stretch IRAs” for non-spouse beneficiaries. This would force all non-spouse beneficiaries to take inherited distributions over no more than 5 years, instead of being allowed to stretch out the distributions over their lifetimes.
If you have not designated a beneficiary, or if the designated beneficiary is your estate, the entire balance of your IRA must be distributed within 5 years after your death. This shorter distribution period means that the beneficiaries of your estate will pay significant income taxes.
Finally, if you name a tax-exempt public charity as the beneficiary of your IRA, the charity can withdraw funds free of income tax. In addition, your estate may be able to take a charitable deduction.
The major takeaway here is to name an individual (or, if done properly, a trust) as the beneficiary of your IRA. Do NOT make your estate the named beneficiary of your IRA.