Beneficiary Designations and Estate Planning for Retirement Accounts

/ October 7, 2013

Elderly Lady with Money - purchased on iStock mgdonohueOne of the most commonly overlooked items I see in client’s estate plans and during probate administrations is retirement accounts and their beneficiary designations. I think this has to do with the cumbersome nature of updating beneficiary designations.  You call the plan administrator or custodian who sends you paperwork with tiny print and all sorts of rules. These forms go straight to the “must do” pile and gather dust. Also, typical beneficiary designation forms are a bit like a Twitter post – you are allowed only a few characters to get your point across and sometimes your point requires more than two lines.  And then, whom should you name? Many clients also have multiple retirement accounts, some from past employers, one from their current employer, a Roth IRA they opened a while back.

Retirement accounts have a lot of complexity, exceptions, and rules. They are built by the tax code, after all. Nevertheless, here are a few tips, ideas, pitfalls, and miscellaneous thoughts to get you or your client thinking about retirement accounts, beneficiary designations, and estate planning . . .

The Stretch.

The “stretch” is retirement account lingo for extending the life of a retirement account and its tax benefits beyond the lifetime of its original owner. (Note: A recent post by Chris Revak discussed the possible end of stretch IRAs.)

Do not name your estate as beneficiary.

If your estate inherits a Roth IRA, all of the great tax benefits available to your heirs are likely out the window. When the estate is the beneficiary of a Roth, the funds must be withdrawn within five years and thus cannot continue to grow tax-free. For a traditional IRA, naming the estate as the beneficiary means that the funds must be withdrawn within five years, unless the owner was age 70.5 or greater, in which case the withdrawal rate is based on the owner’s age (the IRS has a formula for this).

Consider naming your spouse, then your kids, then your grandkids.

A spouse has a great deal of flexibility with IRA and Roth IRA withdrawals. Likewise, a young spouse who inherits an IRA has a longer period of time than an older spouse to stretch out the mandatory distributions. Additionally, a spouse may have the option to “roll” the inherited IRA into his or her own retirement account.  Someone who is 25, for example, has many years over which to take modest distributions, while building a nice nest egg of their own. If you name beneficiaries in generational order of oldest to youngest, the older generation has the ability to disclaim the asset, leaving it to a younger family member who can maximize the tax benefits of the retirement asset. If you only named your spouse and no contingent beneficiaries, then this disclaimer option is not available after your death. Likewise, if your spouse or primary beneficiary predeceases you, and there is no backup, then the asset will likely pass to your estate.  Naming multiple beneficiaries gives your heirs flexibility and provides a back up plan, just in case.  Jen Santini wrote two articles on inherited retirement accounts, one for spouse beneficiaries and one for non-spouse beneficiaries.

Name a Trust as beneficiary.

If you think your spouse or children might cash out the account no matter what the tax advantages are (and lose the opportunity to “roll over” or “stretch”), it is possible to name a Trust as the beneficiary of a retirement account. This is a particularly good idea if the beneficiary is a minor. You should note, however, that this cannot be just any Trust. The IRS has specific criteria for what qualifies as a “designated beneficiary” for retirement accounts. If you have a Trust in place already, a lawyer would need to review it against the IRS’s criteria in order to determine whether it qualifies. If you intend to use a Trust as a beneficiary of an IRA or other retirement account, be sure that it has been drafted with that purpose in mind.

Review, update, and repeat periodically!

It’s a good practice to keep copies of your beneficiary designations with your other estate planning documents and to review them periodically.

Custom Beneficiary Designations.

It is my standard practice to include a beneficiary designation form for all of my estate planning clients. This spells out the beneficiary designation wording that is in accord with the client’s estate plan. Some custodians will take custom beneficiary designation as an attachment or addendum to their standard form.  This is sometimes easier than fitting everything into two lines on a form.

For more information on retirement accounts and estate planning, I would highly recommend the following books . . .

For professionals in estate planning and financial planning, the book to read is Natalie B. Choate’s “Life and Death Planning for Retirement Benefits.” For non-professionals concerned with estate planning, a really great book is Deborah L. Jacobs’ “Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide.”