Naming someone other than your spouse as the beneficiary for your IRA

Naming a beneficiary for your traditional IRA or employer-sponsored retirement plan may be one of the most important financial decisions you ever make. The beneficiary (or beneficiaries) you name will receive the funds remaining in your IRA or plan after you die, so consider your loved ones’ future needs. However, choosing the right beneficiary is often more complicated than that.

If you’re married, your first thought may be to name your spouse as the primary beneficiary of your IRA or plan. Naming a spouse is very common and can make sense for several reasons.

But whether you’re married or not, naming someone other than a spouse as your retirement account beneficiary may sometimes be a better choice.

Children, grandchildren, other relatives, and close friends are popular beneficiary choices for IRA owners and plan participants. You should consider your options and seek professional advice to make the right choice.

 

Advantages of naming a child, grandchild, or other individual

When you take a distribution from your traditional IRA or retirement plan, you generally have to pay federal (and probably state) income tax on all or a portion of it. For federal income tax, distributions are taxed at a certain rate according to your income tax bracket, which depends on your taxable income for the year.

After you die, the distributions that your beneficiary must take from the IRA or plan will be taxed according to his or her income tax bracket. Choosing a beneficiary who is in a lower income tax bracket than you can reduce taxation of the IRA or plan funds after your death. This is one reason that many people name children, grandchildren, and other nonspousal individuals as beneficiaries.

But it may be many years before your beneficiary has to take post-death distributions from your IRA or plan, and his or her tax situation could be drastically different by then. For example, a college student who does not work is probably in a low income tax bracket now, but may be in a much higher bracket 5 or 10 years after graduation. The point is that it can be risky to base your beneficiary choice solely on someone’s current income tax bracket.

 

Naming a non-spousal beneficiary may minimize estate tax

When you die, the funds remaining in your IRA or plan will be included in your taxable estate to determine if federal estate tax is due. (Your state may also impose an estate or death tax.)

This is generally a concern if the value of your taxable estate exceeds the federal applicable exclusion amount. Even if your taxable estate exceeds this amount, though, the unlimited marital deduction allows you to pass unlimited assets to your surviving spouse free from estate tax at your death. This may seem like a compelling reason to name your spouse as beneficiary of your IRA or plan, but there’s more to the story.

If you have a large estate that you leave entirely to your spouse, the combined federal estate tax liability for you and your spouse may be higher than necessary.

The reason? Leaving everything outright to your spouse may waste your applicable exclusion amount. If you leave a portion of your assets to someone other than your spouse (or in a credit shelter trust for your spouse), you can take advantage of your applicable exclusion amount.

The remainder of your estate can be left to your spouse, sheltered by the unlimited marital deduction.When your spouse dies, your spouse’s applicable exclusion amount will shelter at least a portion of his or her taxable estate.

By using both spouses’ applicable exclusion amounts, you can minimize your combined estate tax liability. IRA or plan funds can be used for this purpose if you name someone other than a spouse as beneficiary.

 

Caution: Estate planning for retirement assets is a highly technical area. The right approach depends on your financial and personal circumstances. Be sure to consult a tax professional.

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