How To Leave Your IRA To Those You Love

Deborah L. Jacobs Forbes Staff

Illustration: Polly Becker

Some of the most costly estate planning mistakes I hear about from readers involve retirement accounts. Contrary to popular misconception, they are not normally covered by a will. Instead, the funds go to inheritors according to beneficiary designation forms. You fill out the form when you open an account, but can later amend it. These forms notify the bank or financial institution (the custodian) about who will inherit your accounts. These are your beneficiaries.

Whether you are young or old, married or single, if you’re among the many people who are confused about this, the start of the New Year is a good time to make sure all your beneficiary forms are in order and up to date. If you opened the account years ago, check the designation on file, to make sure it’s what you intend – for example, if you or a family member got married or divorced; or have had children or grandchildren.

A few beneficiary basics: With an IRA, you can readily name any beneficiaries you want, including friends, family members, a trust or charity. For a 401(k) or other workplace plan, you must get your spouse’s written permission to leave it to anyone else. To change a beneficiary – for example, if your spouse died – file an amended form. Make sure to name both primary and alternate (contingent) beneficiaries.

One thing you should never do is name your estate as the beneficiary – a mistake even smart, highly educated people have made. Doing that will cut short the tax benefits. If the account is a Roth IRA, all funds must be withdrawn within five years. For a traditional IRA the same rule applies unless the former owner was already 70½ – the age at which a traditional IRA owner must begin taking required minimum distributions each year. In that case the distribution rate for the heir is based on the age of the person who died.

What if there’s no beneficiary form on file? Heirs are at the mercy of the IRA custodian’s default policy. Most award an IRA first to a living spouse and then to the estate, but some send it straight to the estate, says Joseph Barry Schimmel, a lawyer with Cohen, Chase, Hoffman & Schimmel in Miami. Few custodians will pass on an IRA directly to the kids without a beneficiary form.

You will need to choose beneficiaries for each account. If you have multiple accounts at the same institution, it’s best to do this with a separate form for each – even if you want to distribute all the accounts the same way – rather than trying to cover several accounts with the same form.

The best way to fill out the form will depend on your goals. Here are some options.

Provide for your spouse. For most people involved in a committed relationship, leaving a spouse or partner well provided for is the No. 1 goal in estate planning. They would typically name the spouse as the primary beneficiary of an IRA and, where the form asks for the share, fill in 100%. In case the spouse dies first, though, they should be sure to name contingent beneficiaries as well.

Maximize the stretch-out. Generally, IRA inheritors must withdraw a minimum amount each year, starting on Dec. 31 of the year after they inherit the account. The rules for spouses are more lenient.

If they choose to, heirs can draw out these minimum required distributions over their own expected life spans. This is known as the stretch-out – a financial strategy to extend the tax advantages of an IRA. (There is no automatic right to a stretch-out with a company plan.) Stretching out the IRA gives the funds extra years and potentially decades of income-tax-deferred growth in a traditional IRA or tax-free growth in a Roth IRA. This is a wonderful investment opportunity. Minimum required distributions are based on life expectancy. The longer the life expectancy, the smaller – as a percentage of the IRA balance – each payout must be. From an income tax perspective, therefore, the best designated beneficiary is a young person.

Keep things even-steven. This is an issue that often comes up when leaving assets to children and grandchildren, whether they are primary or contingent beneficiaries. Let’s say you want your three children to have equal shares of your IRA. On the beneficiary designation form, you would list each of them and indicate that they should get one third of the account.

But what if one of them dies before you? Many standard beneficiary designation forms let you provide for per stirpes distributions; that’s the legal term for passing inheritances down to the next generation if one beneficiary dies before the account owner, rather than automatically having that beneficiary’s share go to other co-beneficiaries. For example, let’s say you have three grown children – Harry, Sam and Molly – whom you want to benefit equally with your IRA. If Harry dies before Molly and Sam, checking “per stirpes” on the form would give Harry’s portion to his children, if he has any, rather than dividing it between Sam and Molly.

Preserve the assets. Some forms offer additional options, such as leaving your retirement assets to a trust. You may have good reasons for naming a trust as the beneficiary of a retirement account, says Bruce Steiner, a lawyer with Kleinberg, Kaplan, Wolff & Cohen in New York. For example, it might be worth considering a trust if the intended beneficiaries are minors, you want to keep the money out of the hands of creditors (for example, divorcing spouses) or control the cash flow to heirs you regard as spendthrifts. The trust can essentially force beneficiaries to take advantage of the stretch-out.

However, complex rules govern this strategy. If the trust qualifies as a designated beneficiary, as the tax code and the Internal Revenue Service use the term, it can take withdrawals based on the life expectancy of the oldest beneficiary. If the trust does not qualify as a designated beneficiary, it will still receive the money but may be required to take the payout within as little as five years.

To qualify as a designated beneficiary, a trust must meet various criteria contained in IRS regulations. Pitfalls abound, so ask your advisers to design a trust that meets your goals as well as the government criteria. Then make sure you name it on the beneficiary designation form on file with the financial institution that holds your retirement account.

Give your heirs options. Sometimes a beneficiary will want to disclaim (legalese for decline) an inheritance, typically with the intent of benefiting another person or a specific charity. People who disclaim, known as disclaimants, are generally treated as if they had died before the person from whom they are inheriting. The assets go to the person next in line, or to a specific charity.

To give your heirs maximum flexibility, name both primary and alternate individual beneficiaries – say, your spouse as primary and children as alternates or your children as primary and grandchildren as alternates. Your primary beneficiary then has the option of disclaiming the account, enabling it to pass to the younger alternate. In this scenario, checking the “per stirpes” box on a form that has one can achieve the same result, Schimmel says.

Benefit charity. Given a choice about how to divide up the assets in their estates, some philanthropically inclined people find it more tax-efficient to give retirement assets to charity and leave their heirs other property. This strategy saves both income taxes and estate taxes. A charity, which is tax-exempt, can draw the funds without paying income tax, and if the estate is subject to tax it can take a charitable deduction for the amount left to charity.

The simplest way to make the gift is by directly naming one or more charities on the beneficiary designation form. You can either make the charity a 100% beneficiary of the account or indicate that the charity is a beneficiary of a specific percentage of the funds and have the rest go to other beneficiaries. Another possibility is to name individuals as the primary beneficiaries and charity as the alternate, giving heirs the option of disclaiming all or part of an IRA inheritance to charity; if you want to do this, you should not check the “per stirpes” box on the beneficiary designation form.

For maximum flexibility, you could make the charitable beneficiary a donor-advised fund. This would enable your heirs to disclaim and have the funds go into an account that they could use to recommend grants at any time.

Once you have completed the form, ask an estate-planning lawyer to review it and coordinate your retirement accounts with the rest of your estate plan. The larger your retirement account and the more complicated the estate plan, the harder it may be to cover all the bases with the custodian’s boilerplate. Depending on how the standard form is set up, you may prefer to have your lawyer prepare a customized, more complex beneficiary designation form. Some lawyers will include a couple of customized beneficiary designation forms as part of the standard estate-planning package. Otherwise, you will need to pay extra for that service, most likely at your lawyer’s hourly rate.

Be aware, though, that using a customized beneficiary designation will most likely delay transferring assets to beneficiaries down the line, since financial institutions will need to interpret documents you’ve submitted, rather than simply working with their own, which have been vetted and kitchen tested.

Deborah L. Jacobs, a lawyer and journalist, is the author of Estate Planning Smarts: A Practical, User-Friendly, Action-Oriented Guide, now available in the third edition.

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