IRA Beneficiary Selection

Every week, more than 28,000 people reach the age where they must begin to take mandatory IRA distributions.  When the IRS “simplified” the IRA distribution rules in January 2001, many people mistakenly assumed that the process of distribution planning would now be simpler and that detailed planning was less necessary. But selection of IRA beneficiaries is now more important than ever. 

The new rules have not, in fact, made planning simpler; in truth there are many significant errors in IRA distribution planning that could prevent your legacy from ending up where you really want it to go.

 

Common IRA beneficiary designation errors

When most people select IRA beneficiaries, they select their spouse or their children.  As simple as this seems, this IRA distribution scheme can create problems.  Consider these two scenarios.

When a plan owner leaves an IRA account to the spouse as IRA beneficiary, it inflates the spousal assets. And when the spouse later dies with an estate exceeding $2 million (the estate exemption limit in 2008), they pay estate tax.  By leaving the IRA to the spouse, the deceased spouse has created unnecessary estate taxes by making the survivor’s estate larger.

So instead, they name the son as IRA beneficiary.  But as indicated before, this leaves the son total control over the asset.   He may withdraw the funds immediately and decide to buy a mansion jointly with his spouse (whom the parents dislike).  To complete the parents’ misery, let’s say that the following week, the daughter-in-law files for divorce and gets to keep the mansion in the settlement. Mom and Dad just gave the despicable daughter-in-law a mansion with their IRA money.   Even in death they have money problems. Clearly, the IRA distribution plan of naming the kids or the spouse as IRA beneficiaries can be the worst options as illustrated.

To avoid the above two scenarios, the parents decide to make their IRA beneficiary their “estate.” Many attorneys advise that you never designate an estate as IRA beneficiary, because at death, the IRS requires the account to be rapidly distributed rather than allowed to stretch over the lifetimes of beneficiaries.  Additionally, the IRA will now be a probate asset and subject to claims of creditors.

So how do rich and smart people select their IRA beneficiaries?

They make a trust their IRA beneficiary and appoint a trustee like an accountant, financial advisor, attorney, etc., a person that has good common sense and tax knowledge.

Within the boundaries of Mom’s and Dad’s wishes and IRS-required minimum distributions, the trustee will determine who among the IRA beneficiaries (as named in the trust) will get the IRA and how much they get.  The trustee will determine how quickly this money gets distributed over and above the annual minimum amount of required IRA distributions. Mom and Dad can even give very detailed instructions.  For example, they could dictate no IRA distributions for purchases of homes with the despicable spouse.   Or if the money is to be used for education they may stipulate that up to $15,000 a year can be distributed, or to start a business up to $25,000 can be distributed, and they can go on and on delivering very specific instructions.

Perhaps this particular scenario doesn’t apply to your situation.  That doesn’t mean that your assets are as protected as you think.  Read on.

You probably need an IRA Asset Will

Many plan owners don’t consider what happens if their IRA beneficiary pre-deceases them.

Let’s say you have two sons, Jack and Tom that have been named as the primary beneficiaries for their IRA on the  “IRA Beneficiary Designation Form” on file at the bank or securities firm that holds the account.

As shown in the above illustration, Jack and Tom each have a son.  Jack’s son is Bob. Tom’s son is Dan.  So you write the grandsons’ names on the line of the IRA beneficiary designation form that says “secondary beneficiaries.”

If Jack dies before you, the owner of the plan assets, do you assume that Jack’s share will go to his son, Bob?  Wrong.

It will go to Tom, because on the IRA beneficiary designation form, there is no place to specify how the primary beneficiaries and secondary beneficiaries are related. There is no place for you to explain your intentions or write “per stirpes” to clarify intentions with respect to those beneficiaries.  Those IRA beneficiary designation forms with the bank or the securities firm are not sufficiently detailed to carry out your IRA distribution wishes.

At minimum, you should replace those forms with a custom form, called an “IRA Asset Will.”  Any attorney can inexpensively prepare this.  And if the custodian won’t accept it, move your account to another custodian that will.

As illustrated above, the changes in the IRA distribution rules didn’t change the need for proper distribution and inheritance planning. A failure to understand the details could be very costly to you or your heirs.

Unnecessary liquidation of an inherited IRA

There is no requirement that an IRA be liquidated upon your death.  In most cases, the beneficiary has up to five years to empty the account, but if the account owner dies before they are required to take Minimum Required Distributions, the beneficiary may be able to adopt a distribution schedule over their lifetime.  For a young person, this could amount to 30 years or more of continuing tax-deferred growth.  Allowing the balance to remain in the IRA could net the recipient considerably more money.

Another point to note here is that if you have multiple beneficiaries with a wide range in age (for example, your children and grandchildren), it may be better to divide your IRA into several accounts, one for each beneficiary.  Otherwise the distribution schedule will be based on the oldest heir, thus shortening the deferral time for the youngest.

Note: The Roth IRA is not currently subject to Minimum Required Distributions (MRD) for the account holder but a beneficiary will need to set up a distribution schedule.

Avolid this Foolish Omission–Failing to name a contingent beneficiary

When you die, and your heir dies soon afterward, the IRA becomes part of the estate and must soon be liquidated.  If it passes to a contingent beneficiary, the distribution schedule elected by either you (if you had started MRDs) or your primary beneficiary can continue and allow for additional years of tax-deferral.

Will the IRS See through Your Trust as IRA Beneficiary?

Investors often have trusts as a convenient way for their heirs to receive assets after they die, and generally this works as intended. Everything goes into one pot and each beneficiary takes out his or her share as specified in the trust. IRAs left to your trust, however, can cause complications, and could leave your love ones with less than you had planned.

The IRS views a trust differently than the individuals named in the trust. For instance, suppose you are not taking Required Minimum Distributions (RMD) yet, and named your trust as the beneficiary of your three IRAs. In addition, your trust documents specify that your two daughters, ages 45 and 28, are to receive equal portions of the trust assets after you die. Upon your death, your IRAs will transfer into the trust, and your daughters would receive their shares. However, they will have to start taking RMDs and paying income taxes based on your older daughter’s shorter life expectancy, thus penalizing your younger one.

One way to give your IRA beneficiaries better tax treatment is to create separate accounts for each one of them. For example, you could name your spouse as the IRA beneficiary for one IRA account and each of your children the beneficiary on other IRAs. This might create work for you now, but the end result could be less taxes and greater flexibility for your heirs.

You should review your trust documents and estate plans with your attorney each year or whenever there has been a significant change in your life.

A When a Significant Life Event Occurs, It’s Time to Review Your IRA Beneficiaries

Many investors commit a common estate planning mistake with their IRA assets. Unfortunately, the mistake sometimes becomes apparent only after the account owner dies- when it comes time to transfer the IRA to the heirs. For the intended beneficiaries, these mistakes can lead toextended headaches and heartaches. They can also result in a significant tax bill, which ultimately could reduce the portion of the IRA that heirs will receive.

There is a simple way to prevent the mistake – update your beneficiary designations after significant lifeevents, and add contingent beneficiaries if you haven’t done so already. This too, is a significant part of the estate planning process.

Many people name beneficiaries at the time they opened an IRA, but they never bother to review or update these designations later in life. Because there are several lifeevents that could require a change in beneficiary designations—divorce, re-marriage, the death of a spouse, and the arrival of children or grandchildren – it is important to review and update your beneficiary designations whenever a significant event occurs in your life.

For example, what happens to your IRA should your beneficiary go before you? If you have not changed your primary beneficiary or have not named contingent beneficiaries, your IRA assets could wind up in your estate when you die. Then your heirs could ultimately receive a smaller portion of the account value, due to income taxes, final expenses, and creditor claims.

If your primary beneficiary dies before you, updating your primary beneficiary and naming contingent beneficiaries will help you to transfer your IRA assetsefficiently and avoid probate. Furthermore, your heirs could have the opportunity to stretch out their IRA distribution over their lifetimes. Thus, potentially allowing the account to grow tax-deferred over the lives of two or more beneficiaries and reducing the income tax due. However, without valid beneficiary designations, they may have to take mandatory, larger distributions over a shorter period of time after your estate is settled.¹

Easing the Inheritance of IRAs

Many retirees use trusts to ease the inheritance of Individual Retirement Accounts (IRAs)—but when doing so, there are some rules to be followed to ensure the proper transfer of assets (and avoid a big tax bill).

First, let’s look at revocable living trusts, whichestablish a legalentity with the power to hold title to assets, and are typically used to avoid probate. First, you shouldn’t fund a revocable living trust with an IRA during your lifetime: Doing so would invalidate the IRA and create a huge tax bill. Instead, you should name the trust as the beneficiary on your IRA beneficiary form.

Qualified terminable interest property (QTIP) trusts—which are commonly used in second marriages to provide income to the surviving spouse, defer estate tax until the surviving spouse dies, then pass on the remain asset’s to the first spouse’s children—also present some pitfalls. As with revocable living trusts, you must name the trust as the beneficiary on your IRA beneficiary form. Additionally however, you must instruct your heirs toelect QTIP treatment for both the IRA and the trust on your estate tax return.

But there’s another option to pass on your IRA, which avoids using a trust altogether: The inherited IRA. When an IRA account holder dies, the IRA beneficiary may transfer the assets into an inherited IRA, which allows the beneficiary to keep his or her inherited IRA assets tax-deferred until the IRS requires the funds to be distributed. To set this up, simply name your children or grandchildren (or other desired heirs) as the beneficiaries of your IRA.

When you die, your heirs must simply complete a beneficiary form with the IRA custodian, explaining how to set up and title the inherited IRA. Most IRA custodians need three pieces of information in the title of an inherited IRA: the name of the person who died, the word “IRA,” and a statement that it is for the benefit of (FBO) the heir—forexample, “John Doe IRA (deceased 9/1/06), FBO James Doe, beneficiary.”

After you die, your children caneven divide your IRA account into separate accounts and use their individual lifeexpectancies to determine their withdrawal rates. (Note that the deadline for dividing up an inherited IRA is theend of the year after the owner dies).

¹IRS Publication 590 (2005)

Receive a free copy of the booklet IRA Mistakes.