Designated Beneficiary Trap

Beginning in 2003, new IRS regulations govern the distributions from individual retirement accounts (IRA's). Generally the rules are less confusing and provide for longer payout periods of required minimum distributions as a result of longer life expectancies. Distributions are still required to commence by the April 1st following the attainment of age 70 and one-half. This date is called the required beginning date. The required minimum distribution is the calculated amount providing the lowest amount an IRA owner must withdraw from the IRA each year. By withdrawing the minimum amount each year, the IRA owner can maximize the benefit of tax deferred growth within the IRA for himself and the beneficiary of the IRA upon the owner's death. The beneficiary is able to take the inherited IRA balance out in minimum distributions calculated using the beneficiary's remaining life expectancy upon the IRA owner's death. This type of planning usually works because as an IRA owner approaches age 70 and one-half, the plan custodian alerts the IRA owner to the rules for distributions and the IRA owner's tax advisers can help suggest beneficiary designations that make sense in the particular client's circumstances.

Problems are encountered most times when an IRA owner fails to review their "designated beneficiary" choices during the accumulation years and the owner dies prematurely (before required minimum distributions have commenced). If the IRA owner's estate had been named as the beneficiary of the IRA, the IRA's entire account balance must be paid out by the end of the calendar year that contains the fifth anniversary of the date of death. The opportunity for extended deferral is lost.

Naming a spouse, a child or a grandchild as opposed to your estate can easily solve the problem. The designated beneficiary must be an individual or a trust that qualifies as a designated beneficiary to avoid this trap. An estate can not be a designated beneficiary. 

There are many planning opportunities available in this area and a thorough review of beneficiary designations is a good starting point. Similar rules may apply to employer sponsored retirement plans. We encourage you to consult with us in this important planning.

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