Different types of IRA beneficiaries are subject to different tax rules. For example, a surviving spouse has the most flexibility. They can leave it in their deceased spouse’s name as an inherited IRA and take income without a 10% penalty or, if they are over 59 ½, they can roll the deceased spouse’s IRA into their own IRA and avoid the 10% penalty. An important thing to remember is that no one else can roll a deceased person’s IRA into their own IRA except for a surviving spouse.
For example, children and grandchildren cannot roll a deceased person’s IRA into their own IRA, but they can move it into an inherited IRA. An inherited IRA is not a regular IRA, and the tax rules are different. The biggest difference is your kids will have a required minimum taxable distribution to take every year, no matter how young they are – but there is no early 10% withdrawal penalty for being under age 59 ½ .
The inherited IRA truly is a gift from the IRS. For example, if a 20 year old beneficiary only takes their required minimum distribution each year out of a $100,000 inherited IRA, and it averages 8% per year, they would get over $5,000,000 in income assuming they live to age 83.
Some people want to use their trust as beneficiary. The only good reason to name a trust as a beneficiary of an IRA is for control. For example, if you are leaving IRA money to a beneficiary with bad spending habits, the trust can control the amount of money they can take at any one time. There’s no tax advantage for naming a trust as beneficiary, and in some cases this can cause the beneficiaries to pay more tax.
This is because when you use a trust, you must use the life expectancy of the oldest beneficiary to determine required minimum distributions for all the beneficiaries. This will cause the younger beneficiaries to have to take out more than they otherwise would have to if they could have used their own life expectancy, and worse, this means they have to pay more tax.
If you use a charity as a beneficiary, remember they don’t pay taxes on IRA distributions so the best strategy is to leave tax-deferred IRA money to the charity since they will get it tax free. Then you can leave non-IRA accounts, like joint accounts and single accounts, to your kids which will trigger a lot less tax than the IRA when they take the money out.