What happens when estate is the beneficiary of IRA?

If you have an IRA, you are required to name your beneficiaries in the beneficiary designation form. Once you die, the IRA funds will be passed directly to the designated beneficiaries, who may include a spouse, child, parent, grandchild, charity, estate, or trusts. However, if there is a gap in your IRA beneficiary designations, your estate becomes the default beneficiary of your IRA benefits.

If an estate is the beneficiary of your IRA, it means that the IRA will distribute the IRA assets to the estate, and the estate will share out the IRA funds with the heirs of the estate based on the terms of the IRA owner’s will. However, an estate does not have a quantified life expectancy, and this means that post-death distributions must be made at a faster rate than if the distributions were made to designated beneficiaries. 

Who is an IRA Beneficiary?

An IRA beneficiary is the individual or entity that the IRA owner chooses to receive the IRA retirement benefits after he/she dies. The IRA beneficiary can be a spouse(s), child, parent, grandchildren, trust, or charity.

If the beneficiary is a spouse, the surviving spouse can decide to treat the inherited IRA as his/her own IRA, rollover over to a traditional IRA, or take distributions as the beneficiary of the IRA.

However, if the beneficiary is someone else other than the spouse, they cannot treat the inherited IRA as their own. The beneficiary cannot rollover the inherited IRA into their own IRA or contribute to the inherited IRA. However, you can make a direct rollover to an IRA that is set up in the name of the deceased IRA owner.

If the IRA has a gap in the beneficiaries, either because the named beneficiaries died before the IRA owner or because there are no designated beneficiaries, the estate of the deceased IRA owner becomes the beneficiary of the IRA. You can also designate an estate as an IRA beneficiary, and the IRA assets will be distributed based on the terms of your will.

What happens when an estate inherits an IRA?

When an estate is the default beneficiary of your IRA, it means that the estate will first receive the IRA assets for distributions to heirs of the deceased’s estate. The term “estate” refers to the property you owned at the time of death, and it is a legal entity that is created after you die.

The executor of the estate is responsible for paying any expenses and liabilities and distributing the IRA assets based on the terms of the will. If the IRA owner did not have a will, he/she is said to have died intestate, and the assets are distributed based on the state laws.

The IRS allows two distribution options, based on the age of the deceased IRA owner at death. If the IRA died before the beginning date for required distributions, the IRA funds must be paid out by the 5th year of the IRA owner’s death. You are not required to take distributions each year, but the funds must be fully paid out by the fifth year. If the IRA owner died after the date for required distributions, the IRA must make distributions to the estate over the remaining single life expectancy.

Generally, having your estate as a beneficiary has limited options for post-death distributions. If you had named a spouse, child, or parent as an IRA beneficiary, these beneficiaries would have more favorable post-death distributions. For example, spouses would be allowed to rollover the inherited funds into their own IRA, or spread distributions over their lifetime.

Why should not name your estate as an IRA beneficiary

Here are the disadvantages of having an estate as an IRA beneficiary:

Probate expenses

If your estate is the beneficiary of your IRA, it means that the IRA funds will go through probate before they are distributed to heirs. Probate involves administering the estate of a deceased person and proving a will to be valid. The costs involved in administering the will and the executor fees are charged as a percentage of the estate value, and this creates unnecessary expenses that reduce the amount available for distribution to heirs of the estate.

Estate income taxes

After your death, your IRA funds will be included in your taxable income to determine the amount of federal income tax you owe. Apart from the federal estate tax, your IRA assets may also be subject to a state death tax.

Estates pay higher taxes than individual taxpayers, and the retirement distributions will be taxed at estate tax brackets. The 37% tax bracket applies to taxable incomes of up to $13, 050 for estates in 2022, while for individual taxpayers, the 37% tax rate applies to individuals with a taxable income of up to $523,600.

Limited post-death distribution options

If an estate ends up as the IRA beneficiary at your death, the IRA will be treated as if the IRA owner died without a designated beneficiary. As a result, the IRA distributions will have to be distributed at a faster rate than if there were designated beneficiaries.

If the IRA owner died before the beginning date for required distributions, the IRA funds must be distributed within five years. If the IRA owner died after the date for required distributions, the IRA funds must be distributed over the remaining single life expectancy, up to a maximum of 17 years.