Mistake #3 – Not Properly Designating Beneficiaries
(Best used by having your clients or prospects read)
- 3rd of 10 from the Book “Top 10 IRA Mistakes and How to avoid IRS Tax Traps”
- Stay tuned for “Mistake 4”
The beneficiary form is the single most important document in the estate plan. A common mistake made by retirement plan owners is in the area of beneficiary designations. You would think that choosing who will inherit the money left in your IRA or 401(k) would be simple. The reality is that many children and grandchildren who inherit a qualified plan will be forced into rapid distribution causing rapid taxation due to beneficiary mistakes. Only the IRA owner or inheriting spouse can designate beneficiaries for the purpose of stretching out the distributions and spreading the taxes over the beneficiary’s life expectancy. Here are a few common beneficiary mistakes.
Too Much, Too Fast
Younger or less experienced beneficiaries sometimes inherit too much, too fast. In such cases, the inherited money can do more harm than good! If the beneficiary has limited experience handling money or has a spendthrift problem, they can squander the funds that were intended to support them throughout their lifetime.
Those who save money are usually better equipped to handle money than those who inhert money. Let’s face it, the world holds many temptations, and often beneficiaries will quickly burn through their share of the inheritance. It is estimated that the average inheritance in the U.S. is spent within 90 days to 17 months. It’s no comfort to the diligent saver to imagine a big chunk of their savings winding up on the tables in Las Vegas or the showroom floor of a new car dealership.
A simple planning tool can prevent this from occurring. IRA owners can choose to restrict a beneficiary, rather than allowing them the option of receiving a fully taxable, lump sum distribution. In other words, the IRA owner can specify how the money will be paid to a particular beneficiary. Many custodians of retirement funds offer beneficiary documents that allow the owner to choose a payout period. These payout periods can range from five years all the way to life expectancy. In some cases it may be necessary to use a trust, if your custodian doesn’t offer the option of restricting a beneficiary.
No Contingency Plan
It is common for IRA/401(k) owners to name their spouse as the sole beneficiary of their qualified accounts. As a matter of fact, some states and some custodians require the spouse’s consent to name anyone other than the spouse. Naming a contingent beneficiary is also a vital part of effective estate planning. If both the IRA owner and the inheriting spouse are gone, who will receive the balance left in the account? Business Week Investor addressed this issue in April 2001:
“It’s a little known fact that individual retirement accounts, 401(k)s, and other tax-deferred plans aren’t governed by wills or state inheritance laws. Instead, the disposition of your retirement funds depends on two things: the fine print of your Bank or Fund Company’s custodial agreement and the tiny lines where you listed beneficiaries.”
If the IRA owner fails to designate contingent beneficiaries, the account balance may wind up in probate. Probate can be lengthy and expensive, and during probate the funds are in lock down.
The other problem caused by not designating contingent beneficiaries is the loss of the “Stretch Option”. It is necessary for the IRA owner, or inheriting spouse, to name contingent beneficiaries so they can be treated as designated beneficiaries for the purpose of stretching the inherited IRA. This gives the contingent beneficiaries the option to receive the inherited IRA over their life expectancies and enjoy tax deferral as long as possible. The longer the beneficiaries can keep their inheritance tax-deferred, the longer they can continue to earn interest on what otherwise would have been paid to the IRS before it needed to be paid.
Blending Individual Beneficiaries with Charities
There are four options to consider if you choose to leave all, or some, of your IRA to a qualified charity. Choosing the wrong option can cause big problems for your other non-charity beneficiaries.
- Name the Charity as 100% IRA Beneficiary. If you or your family will not need income from your IRA, you may choose to leave the entire amount to the charity of your choice. The charity’s advantage is that it will not have to pay taxes on the IRA when it receives the benefit. This way, 100% of your IRA will be available to the charity free from income tax. This is a highly tax-advantaged way for senior IRA owners to fulfill their charitable commitments. Some states and some IRA custodians may require the spouse’s consent if the IRA is left to a charity rather than the spouse.
- Split the Beneficiaries between a Charity and Individual Beneficiaries. If you want to leave some of your IRA to a charity and the rest to your spouse or children/grandchildren, you could use a single IRA and divide the proceeds with the beneficiary form. This approach could backfire for the children and grandchildren. If the charity does not take full distribution of its share by September 30 of the year after the IRA owner’s death, the children and grandchildren could lose the advantage of the “Stretch Option”. September 30 is the deadline to determine “Designated Beneficiaries” for the purpose of stretching distributions over the beneficiaries’ life expectancies. If the charity fails to take a full distribution by the deadline, the “Stretch Option” could be lost for your other beneficiaries.
- Split the IRA into Two IRAs. This makes a lot more sense than using one IRA for the benefit of a charity and your children, as described above. You can divide your IRA into one IRA for the charity and a second IRA for your other beneficiaries. Using this approach, your children and grandchildren will be able to take advantage of the “Stretch Option” without regard to the September 30 deadline for the charity. One less deadline is one less opportunity to make a critical IRA mistake.
- Set up a Charitable Remainder Trust. This can be a useful tool if you want to leave income for your spouse as long as he or she is living, and you want whatever is left to go the charity of your choice. Your spouse will have a lifetime of income from your IRA and at the second death, you will have fulfilled your charitable wishes.
Using a Will to Name Your Beneficiaries
If you use a will to name the beneficiaries of your IRA, the beneficiaries will not be considered “Designated Beneficiaries” for the purpose of stretching the distribution over their life expectancies. Instead, if a will is used to name beneficiaries or the IRA owner names their estate, one of the following will occur:
- If the IRA owner dies prior to age 70., the entire account must be distributed and all of the taxes paid by December 31 of the fifth anniversary of the IRA owner’s death. In simple terms, all the taxes on the inherited IRA will be due in five years.
- If the IRA owner dies after age 70., the required distributions can continue to the beneficiaries, but in this case the distributions and tax deferral period will be based on the remaining life expectancy of the IRA owner rather than the longer life expectancy of the younger beneficiary. Either way the beneficiaries lose the advantage of spreading the distributions over their typically longer life expectancy and lose much of the value of the “Stretch Option”, as well.
Using a Trust to Designate Multiple Beneficiaries
It is not uncommon for IRA owners to own a trust. It’s also not uncommon for them to use the trust to determine who will inherit the balance of their IRAs. This is a frequent, and costly, beneficiary mistake. Most IRA owners will have multiple beneficiaries and they will have different ages. Because of the age difference, they also have different life expectancies and different “Stretch” payout periods.
Here is an example of what can happen when you use a trust to designate multiple beneficiaries:
A 45-year-old beneficiary has a “Stretch” payout period of 38.8 years, while a 12-year-old beneficiary has a “Stretch” payout period of 70.8 years (according to IRS Publication 590). For both of these beneficiaries to be able to use their individual life expectancies for stretching the distributions from an inherited IRA, separate accounts must be established. Unfortunately, the beneficiaries of a trust cannot use the separate account rule. That means both beneficiaries will be treated as if they are the age of the oldest beneficiary. In this case the 12-year-old beneficiary will be treated as if they were age 45. This will greatly diminish the payout period and total IRA income for the 12-year-old beneficiary. This will be discussed further in the next chapter.
Not Keeping Your Beneficiary Documents Up-to-Date
Failing to update beneficiary documents is the most common IRA beneficiary mistake.
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