Individual Retirement Accounts (Part 1 of 5)

by Dennis W. Donnelly, CPA, PFS

Dear clients and friends,

Individual Retirement Accounts are an important tool in your retirement arsenal. Many of us set them up, make our regular contributions, and don't give them another thought. However, there are some potentially disturbing unintended consequences when details of the IRA are not carefully considered and properly executed. We will examine some of these issues in this five part series.

Some Basics

To encourage individuals to save for retirement, the Internal Revenue Code provides special tax breaks for those who contribute to traditional and Roth IRAs. Traditional IRAs can be established by anyone who is younger than 70½ at the end of the year, and has earned income (wages, salaries, payment for personal services.)

Unlike traditional IRAs, Roth IRAs impose no age limitation on who can make a contribution. A person can establish and contribute to a Roth IRA as long as he or she has earned income. Roth IRAs do impose one limit for eligibility, which is based on a person's income. Only those whose adjusted gross income is within or below certain levels can contribute to a Roth. In 2013, these amounts are $112,000 to $125,000 for single individuals and for married couple filing jointly the limit is $178,000 to $188,000.

With both types of IRAs, the same contribution limits ($5,500 if under 50 years old, and $6,500 if over 50 years old) apply to the amount that can be contributed each year and the tax rules prohibit the perpetual sheltering of retirement funds in both types of accounts. While traditional IRA owners must begin taking distributions by April 1 following the year in which they turn age 70 ½. Roth IRA owners are not required to take distributions during their lifetimes, however, once a Roth owner dies, IRA funds must be distributed to beneficiaries who may have to recognize distributions.

Because IRA funds must eventually be distributed and taxed, it is crucial for IRA owners to plan for this eventuality. The first, and perhaps the most important step, is for owners to carefully select the beneficiary.


Many are under the mistaken impression that when they die, their IRAs will be distributed according to the terms of their wills. There are certain types of assets that instead pass to heirs by operation of law or based on the beneficiary designation form. In other words, a will's provisions do not affect how these assets are transferred.

For example, if a person owns a joint banking account or brokerage account with a spouse, the entire account passes to the surviving spouse at the other's death. Spouses who own a home as joint tenants with rights of survivorship will also find that the house passes to the other spouse at death, regardless of what a will might say. IRAs and life insurance will bypass the probate process and pass directly to the named beneficiary per the directives in the beneficiary form. For this reason, IRA owners must be certain to update the beneficiary form whenever a significant life event occurs...such as a birth, divorce, marriage, or death. Otherwise, an IRA owner could inadvertently disinherit a loved one. For example, IRA assets may pass to an ex-spouse instead of a current spouse or may bypass grandchildren if a child dies before the IRA owner, if the beneficiary forms are not properly updated.

What happens if there is no beneficiary form on file with the IRA custodian (that is, the bank, broker, or mutual fund Companies holding the IRA account) or if a person fails to name a beneficiary? In these cases, the beneficiary will be chosen according to the custodian's default policy, which will vary depending on the IRA custodian. Some custodians, for example, will transfer an IRA first to a surviving spouse and then to the estate. Others will pass the assets directly to the estate, while a small minority will transfer such assets directly to the owner's children when there is not a beneficiary form.

Even if a person has an up-to-date beneficiary form, but it cannot be located after an owner's death, the result is the same as if a beneficiary had not been named; the IRA will pass according to the IRA custodian's default provisions. Consequently, IRA owners must ensure that a beneficiary form is on file with the bank, broker, mutual fund company, or financial advisor, and that instructions are left regarding where the form is located so that the beneficiaries can find it when it is needed.

Designated Beneficiaries

Naming a beneficiary for an IRA is perhaps the single most important act an owner can take to protect heirs and ensure that his or her wishes are carried out after death. As we will see, who the named beneficiary will impact how IRA assets can and must be distributed after an owner's death. In fact, a critical factor that influences the manner in which distributions must be made is whether there is a designated beneficiary, a concept which will be explained next.

Individuals are free to name any person or entity they wish as beneficiary of their IRA. However, the choice of beneficiary can have a critical impact upon the distribution of funds that remain in the IRA at the owner's death. Notably, if a person dies and has named a designated beneficiary of his or her IRA, the IRA funds can be distributed based on the beneficiary's life expectancy. If there is no designated beneficiary, the distribution of the assets will be accelerated, possibly leaving heirs with significant tax problems. The term 'designated beneficiary' has a very specific meaning with respect to the distribution of IRA assets at death rules. For this purpose, according to the Internal Revenue Code, a designated beneficiary must be a natural person, such as a child, spouse, parent, sibling, or friend, a living being for whom a life expectancy can be determined. A designated beneficiary cannot be a non-natural entity, such as a charity, a corporation, a nonqualified trust, or the owner's estate. Even if one of these entities is named as co-beneficiary along with a spouse or other person, the IRA is still considered to have no designated beneficiary.

A non-natural entity may be named as a beneficiary of a person's IRA account, if that is the owner's wish. However, doing so will disqualify the account from being able to use an extended distribution period upon the owner's death. The result is a faster distribution of the IRA assets and the loss of additional future tax-deferred accumulation for the account. In other words, the IRA assets must be withdrawn soon after the owner's death, sometimes in a lump sum, when the taxes would be due immediately. The long-term value of a tax deferred IRA will therefore be lost.

In our next installment, we will discuss Primary and Continuent Benficiaries; spouse and non-spouse beneficiaries and the consequences of 'No Designated Beneficiary.'

Go to Part 2.

Very truly yours,

Dennis W. Donnelly, CPA, PFS
Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Michael R. Gohde, CPA, PFS