Function

• IRA owners can fill out paperwork with their custodians to designate one or more IRA beneficiaries to inherit the account immediately after they die. In addition, they can name contingency beneficiaries who would own the account should the first beneficiary decline the inheritance or pass away before the owner. Should the original owner fail to name any beneficiaries, the IRA passes to the estate.
  
  

Tax Significance

• Designated spouse IRA beneficiaries can treat an inherited IRA as their own, by continuing to contribute to it and delaying withdrawals as long as possible. Non-spouse beneficiaries must either empty the account after five years or begin taking Required Minimum Distributions, or RMDs, the year following the original owner's death. Many beneficiaries prefer the latter option because it stretches the IRA's tax shelter for as long as possible.
  
  IRA beneficiaries calculate their annual RMD by dividing the account's worth the previous December 31st by their life expectancy according to IRS tables. The younger the beneficiary, the longer his life expectancy and the smaller his RMD. Estates, however, have no life expectancy, and therefore IRAs that pass to estates must be emptied within five years.
  
  

Legal Significance

• People planning their estates often designate loved ones as IRA beneficiaries precisely because the accounts are not entered into probate. Designated beneficiaries can begin directing an IRA immediately -- buying and selling assets inside the account to meet their financial goals. In probate, the account is in limbo while a judge decides who should inherit it. If the original owner had creditors, or if the will is contested, the IRA's assets could be tied up as long as it takes the court to adjudicate the estate.
  
  

Warning

• If an IRA passes to probate, the estate must empty the account within five years. If the account was a traditional, SEP or SIMPLE IRA, the inheritors will be taxed on their withdrawals at their income tax rate. Large IRAs have the potential to bump inheritors into a higher tax bracket. If this is a possibility, inheritors might want to withdraw a portion of the IRA each year over five years to minimize their tax burden, rather that take all the money in one year.
  
  

Prevention/Solution

• IRA owners who want to designate a spouse, child or loved one to inherit their account should immediately talk to their IRA custodians and ask for the appropriate paperwork. Usually, owners must fill out a short form that gives custodians basic information about the beneficiaries. Should plans change or the one of the beneficiaries pass away, owners can update the forms. It is very important that owners do all of this with their IRA custodians, banks or financial institutions that hold the account. Naming IRA beneficiaries in a will makes the account subject to probate.