Last week, my friend Rose called me. She was visiting her 80-year old mother, when her mom got a call from an advisor at the financial institution that holds her IRA account, telling her it was time to take her annual distributions and that she should really name a beneficiary. My friend asked me to shed some light on the phone call. Your mom is 80, I explained that ever since her mom turned 70 1/2, she’s needed to take what are called minimum required distributions on her IRA. So she would have to do that this year, too, and the amount of the distribution increases each year as she gets older. But, are you telling me she has no beneficiaries listed? Yes, my friend said. My mom just figured it would go to her estate and then go to me in the same way her will gives the rest of her estate to me as her only child. Well, that’s true, I explained — since your dad passed away a long time ago, leaving it to the estate would get it to you, ultimately. BUT, that will also come with some major income tax ramifications to you and really hurt the growth potential of those funds.

This is a mistake that is commonly made. And, it really underscores how important it is for people to understand how IRAs function over the long term, and how small mistakes like this have big consequences. So let’s back up. Most IRAs are tax-deferred investments, meaning that the money that went into them were from pre-tax dollars and that income tax will be due upon withdrawing money from the account (not so with Roth IRAs).

IRAs are attractive retirement vehicles for good reason: since you don’t first have to pay income tax on the money going in, you can sock away larger amounts even early in your career, and watch all that money grow and compound tax-free for decades. When you turn 70 1/2 years old (although there is some ability to defer until the April 1st of the year that follows the calendar year you turn 70 1/2), you are required to start taking annual minimum distributions that are calculated based on your life expectancy. Those distributions are then taxable as income to you as the recipient, subject to your income tax rate at the time the distributions are made. Keep this point in mind – I’ll come back to it shortly.

IRAs have their own beneficiary designation forms. If you’ve ever had a job where you’ve participated in a retirement plan, you may remember your HR department having you fill out a form like that when you started your job. You may have wondered why the HR person was intent on tracking you down for that form. That is because for an IRA to function the most effectively and reap the greatest possible benefit, you need to have beneficiary designations on file with the financial institution that is the custodian of the IRA.

Now, back to the income tax issue. As I mentioned, Rose’s mother has to take minimum required distributions each year. Because those distributions are based on her life expectancy (that is, in turn, based on actuarial tables), the amount she has to withdraw each year as minimum distributions are going to be a relatively large percentage of the IRA’s principal for a woman who is 80, and that amount is all considered taxable income.

Now let’s say Rose’s mother properly filled out her IRA beneficiary form, naming Rose as the beneficiary of her IRA. If she passed away, then as the IRA’s beneficiary, then the assets in the IRA would transition into a beneficiary IRA account for Rose. Rose would then have to start taking minimum required distributions (just as her mother had) within the calendar year following the year of her mother’s death, except that, instead of calculating the distributions based on her mother’s life expectancy, the distributions are now calculated based on Rose’s life expectancy. In other words, the denominator in the calculation increases. Given that Rose is 50 years old, that translates to two things: (1) smaller distributions, and (2) decades’ more worth of growth in the IRA principal. Smaller distributions mean a lower income tax burden when the distributions can be spread out over a longer period of time, particularly when a 50 year-old might be in the highest tax bracket she will ever occupy. This is what is commonly referred to as the IRA “stretch” — the ability to stretch the minimum distributions over a longer life expectancy.

Let’s contrast that to a situation where Rose’s mother failed to name beneficiaries or named her estate as the beneficiary. Under this scenario, her will (naming Rose as beneficiary) would lead the IRA to be distributed into a beneficiary IRA to Rose, but now the entire landscape of the distributions becomes vastly different.

Under this scenario, the IRS rules say that Rose’s beneficiary IRA must be fully distributed within 5 years of her mother’s death. While the distribution can happen all at once or in parts, all of it must be completed within 5 years. And it can lead Rose to lose money in three different ways, which is ironic, considering that her mother was trying to leave everything to her. First, the five-year distribution rule can translate to a very hefty income tax bill for Rose in a short period of time, and she will have to come up with the cash to pay that tax bill. Second, that additional income from the rush of distributions within five years might even bump Rose into a higher tax bracket, which is certainly not the result that Rose anticipated — now she not only has a large tax bill for the IRA distribution, but also has a higher tax bill on all of her income. Third and finally, in failing to have specific beneficiaries designated for the IRA, her mom unwittingly killed the IRA’s stretch potential, taking away what could have been decades of tax-free growth and a significant legacy for the daughter to whom she wanted to leave everything.

Sheri Hametz is the founder of Peak Executor Solutions LLC. She holds a degree in Economics from Brown University and a law degree from New York University School of Law. Peak Executor Solutions provides services to help estate executors understand, organize and accomplish the work ahead of them. 914-420-2031;