It seems innocent enough—Joe dies with an Individual Retirement Account. Joe named his wife, Sally, as the beneficiary—so far so good.
Sally is overwhelmed with not only grieving over her lost spouse, but also all of the trauma and details that follow someone’s death. There’s the planning for the funeral; gathering with family; filing for insurance claims; paying the final medical bills; changing the title on the car; dealing with probate…the list seems endless!!
Days quickly turn into weeks that quickly turn into months. With so much going on, Sally doesn’t feel the need to claim the IRA benefit from Joe’s IRA—BIG MISTAKE!!
Normally, it’s no problem to wait, but, unfortunately, Sally died before claiming Joe’s IRA.
Here’s the problem: an IRA typically not only has a named primary beneficiary but also a contingent beneficiary. If the primary beneficiary (Sally) dies after the IRA owner (Joe) dies but before claiming the benefit, the IRA pays to the estate of the IRA beneficiary (Sally).
No big deal, right?
Joe’s will names Sally as the sole heir of his estate, so problem solved—Sally (her estate) still gets the IRA proceeds.
True, the IRA still ends up in Sally’s estate, but now the proceeds have to be paid out based on the rules for distributions from her estate because Joe’s IRA never got transferred to her IRA so she could name a new beneficiary.
This is where the problem lies—the estate has no life, so the IRS requires that the IRA be paid out over no more than 5 years (or based on Joe’s life expectancy if Joe was taking his Required Minimum Distribution). So, instead of Sally or the contingent beneficiaries being able to take the IRA out in annual installments over her/their lifetime, the taxes will be paid earlier and, most likely, at a higher tax bracket—OUCH!
PlanFIRST had a client situation very similar to this happen recently, but, fortunately, our advisor was diligent about getting our surviving client to sign the paperwork to open her IRA before her unexpected death—just six weeks after her husband’s passing.
Your IRA custodian may not follow this same process, but to err on the side of safety, be sure to file a claim for benefits as soon as possible after the IRA owner’s death. It may seem a little heartless, but the IRS doesn’t care.
This is also a good time to remind you that this same scenario could occur if you don’t name a contingent beneficiary. In that case, the proceeds are always paid to the estate with the same tax treatment discussed earlier.
The situation would not have been critical if the IRA was a Roth IRA versus a Traditional IRA since Roth IRA distributions are tax-free.
As always, please discuss your particular situation with a financial/tax professional before taking any action!
