One important aspect of estate planning is a properly completed, well-thought-out beneficiary designation for retirement accounts and IRAs. If completed correctly, the beneficiary designation not only indicates who receives the underlying assets of the account upon the plan holder’s death, it also may allow for such assets to avoid probate.
It is painful to witness the troubles that arise when people who don’t work with a knowledgeable provider, such as Trust Point, make some all-too-common mistakes with beneficiary designations. Before we get into those mistakes, however, we’ll need some background on how retirement plans and beneficiary designations work.
A beneficiary designation passes property from one party to another by operation of law. Here’s the significance of that phrase: Provided there is a beneficiary designation on file that identifies individuals or organizations alive (or in existence) at the time of the account holder’s passing, the assets are not subject to probate and just vest immediately to the designated beneficiary.
“Probate” refers to court oversight of an estate’s administration. Probate can be expensive, time-consuming, and sometimes unresponsive to the deceased person’s wishes. Therefore, avoiding probate is generally seen as highly desirable.
Now let’s look at a few basics about the taxation of retirement plans and IRAs. For traditional IRAs and non-ROTH components of other retirement plans, the account owner is allowed to reduce taxable income or wages by the amount contributed. During the life of the plan, the account benefits from tax-deferred growth, meaning the owner is not required to report annual interest, dividends, or capital gains on the investments within the plan. However, when distributions are made to the plan holder, those distributions are taxed as ordinary income at the plan holder’s marginal income-tax rate in the year they are received.
For Roth IRAs or Roth components of other retirement plans, the account holder does not benefit from a reduction in taxable income or wages at the time of funding; instead, contributions are made with after-tax dollars. However, during the life of the plan, the annual earnings are not taxable. And, when distributions are made to the plan holder they are not taxed. This is called tax-free growth.
How do these retirement plans deal with beneficiaries? The SECURE Act, effective January 1, 2020, eliminated the so-called “stretch” provision for most (but not all) non-spouse beneficiaries of IRAs and other retirement accounts. Under the previous law, non-spouse beneficiaries, if they continued to hold the funds in the deceased account holder’s name in an inherited plan, could take annual distributions based on a calculation using their life expectancy. This allowed the beneficiary the continued benefit of the plan’s tax features: either tax-deferred growth for a traditional IRA or retirement plan or tax-free growth for a Roth plan. The SECURE Act now places a 10 year limit for full distribution of inherited plans for most non-spouse beneficiaries. If an IRA holder passes or an inherited plan is in existence prior to January 1, 2020, non-spouse beneficiaries continue to benefit from the pre-SECURE Act rules allowing for lifetime deferral.
The adoption of the SECURE Act can also impact certain types of see-through trusts which have been drafted to serve as beneficiaries of retirement accounts. Trust documents should be examined to ensure the intended goals of the Trust can still be met under the new rules, or if adjustments to the Trust are needed.
Hopefully that all sounded pretty straightforward. So what can go wrong? Firsthand experience tells us that when beneficiary designations are not carefully considered, the answer is: plenty.
The Top 5 Beneficiary Designation Mistakes
1. Not naming a beneficiary or naming your estate as beneficiary
Naming your estate when you complete the beneficiary designation for the funds in your retirement plan—or not completing the designation at all—most likely will result in the assets being pulled into a probate estate settlement. The drawbacks are many:
- Probate often is a slow and costly way to distribute assets.
- State statutes, not you, determine who receives the plan’s assets.
- Assets from the plan can be used to pay your estate’s creditors.
- There is a greatly reduced chance that the opportunity for tax-free or tax-deferred growth will pass along to your intended beneficiaries
2. Not keeping beneficiary designations up to date
It is essential to revisit your beneficiary designations, especially in connection with life-changing events such as marriage or divorce. The most imperative situation may be divorce. If you don’t complete an updated beneficiary designation, and you originally named your former spouse as the beneficiary, that former spouse will receive your plan assets upon your death.
Regardless of whether your designation is updated at the time of marriage, your spouse is deemed your primary beneficiary by law. Ordinarily, this is the desired outcome. But if it is not what you want — due to other estate-planning considerations — your designation must be updated to name a different beneficiary, and your spouse must acknowledge agreement by signing the beneficiary designation.
3. Failing to name contingent beneficiaries
Generally, a primary beneficiary is named at the time the retirement plan is started. But what happens if your primary beneficiary predeceases you, or if you pass simultaneously? Unless a contingent beneficiary is named, the result is the same as if you had designated no beneficiary at all (see #1 above).
4. Naming minors as beneficiaries
Much time and effort often are put into estate plans to establish trusts or to name guardians who can manage the finances of minors who stand to inherit substantial assets. Similar care should be taken when a minor is named as the primary or contingent beneficiary of a retirement plan or IRA.
You also may want to consider additional oversight for young-adult beneficiaries. Is your 22-year-old son equipped to manage the assets and make appropriate long-term planning decisions? Remember that at the time of your passing, your IRA fully vests in the beneficiaries. They can use the assets for further education, a first-time home purchase—or to underwrite an unforgettable Spring Break excursion for 20 of their closest friends.
5. Failing to coordinate estate-planning documents and beneficiary designations
Beneficiary designations for retirement accounts are an extension of your overall estate plan. It is important to review them in conjunction with each other to make sure the outcomes will work as you intended. For example, it probably would occur to you to update your will or revocable trust to make sure that assets covered by those documents provide for your spouse and equally for your three children. But suppose you forget to update the beneficiary designation for your retirement plan, which was completed after your marriage but before your children arrived? It names your spouse as the primary beneficiary and your cousin Jack as the contingent beneficiary. If your spouse should predecease you, do you really want your plan to pass to cousin Jack and not your children?
Here is the message in a nutshell: The assets in retirement plans form a growing portion of many people’s overall wealth. It is important that beneficiary designations be completed and reviewed with care to ensure that when you pass, those assets go where you wish. Let Trust Point’s credentialed relationship managers assist you with reviewing your beneficiary designations. We can help ensure that the wealth you have worked hard to create is passed to the recipients you actually intend, as tax-efficiently as possible.