Not Designated Beneficiary: What It Is and Requirements

What Is a Not Designated Beneficiary?

The term not designated beneficiary refers to a nonperson entity that inherits a retirement account. This beneficiary is appointed as such under the Setting Every Community Up for Retirement Enhancement (SECURE) Act to take required withdrawals. The SECURE Act passed in December 2019 and is effective for all inherited retirement accounts as of Jan. 1, 2020. Not designated beneficiaries inherit a deceased individual's account when there is no named beneficiary. Trusts are common examples of nondesignated beneficiaries.

Types of Beneficiaries

The SECURE Act established three classifications of beneficiaries based on the individual's relationship to the original account owner, the beneficiary's age, and their status as either an individual or nonperson entity. The three classifications available for a person or entity that inherits a retirement account are:

• Eligible designated beneficiary (EDB)
• Designated beneficiary (DB)
• Not designated beneficiary

For inherited retirement account withdrawal rules and requirements, a retirement account beneficiary that is a nonperson entity is considered to be a non-designated beneficiary. Also called a nondesignated beneficiary, it has no life expectancy of their own, as they are not living persons. Common examples of this type of beneficiary include estates, trusts, or charities.

These types of beneficiaries must follow the five-year rule or the payout rule for the account. Which rule applies depends entirely on the age at which the account holder dies, either before or after the age for required minimum distributions (RMDs).

Requirements for Not Designated Beneficiaries

Estates, charities, and trusts are typically classified as not designated beneficiaries, as they are not individuals. Depending on the age of the retirement account owner at their date of death, the not designated beneficiary will be subject to one of two rules: the five-year rule and the payout rule.

Five-Year Rule

The five-year rule applies if the owner dies before age 72 (or 73, starting in 2023), the RMD age as of 2020.

This rule stipulates that the beneficiary must withdraw the remaining balance of the retirement account for five years following the owner’s death. There is no RMD in any one year, but the account must be fully depleted by Dec. 31 of the fifth year following the owner's date of death.

Payout Rule

The payout rule applies if the owner dies after age 72 (or 73 after 2023). This rule stipulates that the beneficiary may take out the remaining balance over what would have been the owner's remaining life expectancy had they not died. Under the payout rule, there is a set RMD that must be taken out each year.

The beneficiary is allowed to take out more than the minimum required distributions. In the case of a charity (which does not have to pay income tax on inherited retirement assets), the beneficiary may choose to take all of the funds immediately.

For beneficiaries subject to income tax, it makes more sense from a tax perspective to delay withdrawals as long as possible. Taking only the RMD allows the maximum funds to continue to grow tax-deferred.

Exceptions to Not Designated Beneficiaries

The beneficiaries of a trust are used to determine the classification of the beneficiary of an IRA rather than the trust itself. There are two main types of see-through trusts to be aware of when identifying the trust's beneficiaries for classification purposes.

Conduit Trust

If the trust identifies a specific beneficiary or beneficiaries to receive all withdrawals from the IRA account, that individual or entity is treated as the direct beneficiary of the IRA. A conduit trust is unable to accumulate any funds before disbursing IRA withdrawals directly to its beneficiaries.

For example, if the only beneficiary identified by the trust is an estate or charity (a nonperson entity) the IRA is treated as having no designated beneficiary. On the other hand, if the beneficiary identified by the trust is an individual, the IRA is treated as having either an eligible designated beneficiary or a designated beneficiary, and the respective rules apply, depending on that individual’s classification and relationship to the decedent.

Accumulation Trust

Alternatively, if the trust can accumulate withdrawals from the IRA instead of disbursing withdrawals to the beneficiaries, it is considered an accumulation trust. This type of trust accumulates and disburses funds to its trust beneficiaries over time, as in a spendthrift protection situation.

Assume that a trust identifies the account owner's four adult children as beneficiaries but it also states that the funds must be disbursed to these children in amounts no more than $10,000 per person per year. Because the trust has the power to accumulate and disburse the funds according to a pre-approved schedule, it is considered to be an accumulation trust. In this case, the four adult children are identified as the beneficiaries, and the 10-year rule for DBs goes into effect.

Because an accumulation trust usually identifies an estate or charity as a beneficiary in some capacity, it is typically subject to either the five-year rule or the payout rule for not designated beneficiaries. Even if all funds must be distributed from the retirement account in a short time, the trust may accumulate and hold the assets according to the owner's pre-approved schedule. Accumulation trusts are harder to draft than conduit trusts, but a trust that can protect inherited assets longer may be a better choice for many retirement account owners.

The Bottom Line

Naming beneficiaries for your retirement accounts is an important part of your retirement planning. Doing so can help your heirs avoid probate and, in some cases, taxation. If you don't assign your beneficiaries, your account may end up in the hands of a not designated beneficiary. This entity isn't a living person, such as a trust or charity. When one of these is assigned to become the beneficiary of your IRA, it must either liquidate the account within five years of your death or follow the payout rule, depending on the age at which you die.