I have talked before about the options available to clients hoping to avoid a probate of their estate. One easy way to bypass the probate process is to execute “payable on death” or beneficiary instructions on financial accounts. This can be done on everything from insurance policies to bank accounts. When it comes to Individual Retirement Accounts, or IRAs, the importance of designating beneficiaries becomes much more significant. Even if you’ve embraced the idea of probate, IRAs are one investment that should always designate beneficiaries who will receive the account balance upon the owner’s death.

IRAs provide significant tax benefits if used properly. Traditional IRAs allow annual contributions of up to $5,500 in pre-tax income ($6,500 if you’re over 50), which means that your contributions can be deducted from your gross income, thereby lowering your tax liability. Once contributed to the IRA, that money generally grows over time. It’s taxed when it’s later distributed to the account owner. No distribution can occur before age 59½ without a penalty. Minimum distributions must begin by April 1 after the year in which the account owner reaches the age of 70½. Minimum distributions are determined by the account owner’s expected lifespan; the longer you’re expected to live the smaller the distributions will be. Taking just the minimum distribution allows the bulk of the account balance to continue producing tax-deferred income over a greater period of time.

(A Roth IRA offers no tax benefit when a contribution is made, so the money is taxed as income in the year in which it is earned. However, the money grows over time and then gets distributed later tax-free. In exchange for paying tax up-front, an investor might receive much more down the road, tax-free. Rules governing Roth IRAs are different than those discussed below.)

Because traditional IRAs are taxed upon distribution, which can occur over time, there is often a pool of taxable assets remaining in the IRA when the account owner dies. That’s why the designation of beneficiaries is a common and critically important part of starting an IRA. If a surviving spouse is named as the beneficiary, he or she can roll the remaining balance over into his or her own IRA, and take distributions accordingly. Non-spousal beneficiaries (children, grandchildren, friends, etc.) cannot roll over an inherited IRA into their own, but then can elect to take minimum distributions that are calculated over their own expected lifespan. For very young beneficiaries this can result in a very small minimum distribution and, potentially, decades of continued tax-deferred growth.

But, when an IRA doesn’t name a beneficiary, there’s a risk that the decedent’s estate becomes the beneficiary. When that happens, the distribution options become much less attractive. While the account balance would pass to the estate’s beneficiaries proportional to their share of the overall estate, those beneficiaries would have to take distributions over just five years, or according to the decedent’s distribution plan (depending on the account owner’s age at the time of death). Either way, distribution occurs over a shorter period of time, which means less income and a faster payment of taxes. Passing an IRA through an estate is, therefore, a much less attractive option, and explains why naming a beneficiary on an IRA is so important.

We often discover IRAs without beneficiaries when a surviving spouse dies. When opening the IRA account, a married account owner typically names his or her spouse as the beneficiary. However, if the spouse dies first, the account owner sometimes fails to return and name a new beneficiary. As a result, the IRA passes to the estate instead of select individuals. That’s why regular reviews of your estate plan are so important, and should occur every five years or so, and especially after major life events. It provides a chance not just to review the terms of a Will and Powers of Attorney, but also to check investments and other financial accounts to be sure your designations of beneficiaries are up to date. The savings for those you leave behind could be substantial.

Lance A. McNaughton practices estate planning, probate, business, and real estate law, including landlord-tenant cases, in both Lafayette and Green Counties in Wisconsin. He can be reached by e-mail at mcnaughton@swwilaw.com.