Beneficiary designations are something people often forget about when preparing for retirement. That can be a very costly mistake. This post offers 7 things you need to know. The bottom line: IRA beneficiaries matter – A LOT!
In my financial planning practice, Leamnson Capital, I often review retirement account (IRAs, 401(k)s, etc.) beneficiary designations for the people I meet. It's common to find that the beneficiaries people think they have are not named in their accounts.
IRA beneficiary designations (as well as any other financial assets with beneficiaries) need to be reviewed on a regular basis. Life circumstances change. Divorce happens. Children (often named as beneficiaries) become irresponsible. Sadly, spouses and children die. That's why it's so very important to do this regular review.
With that in mind, here are my top 7 things you need to know about IRA beneficiaries. There are many more, but this should give you plenty to think about.
IRA beneficiaries avoid probate
Probate is the legal process each state uses to transfer property to the heirs of the deceased (for more, read Do I Need an Estate Plan). A well planned and executed will helps make that process go smoothly. However, property passing via a will goes through probable.
Life insurance policies, annuities, transfer on death (TOD) accounts, and other retirement accounts also have named beneficiaries. These beneficiaries receive the money directly from the company that holds the accounts (insurance company, brokerage firm, bank, etc.). Once the companies verify the beneficiaries, they either cut a check for the account value or make arrangements to transfer the assets directly to an account in the name of the beneficiary.
Passing property this manner is an incredibly efficient way to transfer assets at death. It costs no money and gets to the beneficiaries much more quickly than through probate.
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IRA beneficiaries matter – especially in divorce
Here's what I mean.
Money issues are one of the leading causes of divorce. Divorce, by itself, is traumatic. Dividing the property in a fair and reasonable manner is often even more traumatic. So, let's say a married couple decides to divorce (hope that never happens).
Their attorneys have slugged it out and reached a settlement agreement to split the property. A qualified domestic relations order (QDRO pronounced qua-dro or cue-dro) is the legal document that divides retirement accounts (401(k), 403(b), etc.). IRAs are not part of the QDRO and settle separately. It is common for the spouse (especially the non-working spouse) to get half of the money in these accounts. There are numerous issues involved in dividing these accounts that fall outside the scope of this article. To learn more, read Divorcing? The Right Way to Split Retirement Plans.
After you've agreed on distributing the IRAs, what happens to the beneficiaries? For the one whose accounts stay intact, nothing unless the account owner changes them. When the receiving spouse has his/her own IRA, and that account receives these funds, the same thing is true. Not changing beneficiaries may leave both ex-spouses as the beneficiary of each of their accounts. And some cases, that is what they want. However, if it isn't and beneficiaries don't get changed, the desired beneficiary will not get the funds.
Those who remarry after divorce usually want their new spouse to get IRA funds upon death. Or they may want their children or someone else to be the beneficiaries. Unless they take the old names out and put the desired names in as beneficiaries, the old beneficiaries inherit those IRA assets. I've seen this mistake made more than it should be.
Sadly, there is little recourse available. The IRS has an appeals process in place. It's a very expensive process. Most of these appeals are not successful. IRAs are contracts governed by law. Typically, the IRS goes with what the IRA contract says.
If you want your kids or someone else to get your IRA funds after divorce, the only way to assure that happens is to name them.
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If possible, never name your estate
Remember, named beneficiaries receive funds from IRAs directly from the custodian. They do not go through probate. If the estate is the beneficiary, the opposite is true. The estate is not an individual. Therefore, the court looks to the will to determine how to distribute the IRA proceeds. In the absence of a will, the probate court of each state determines how to distribute the property.
Naming the estate, either by not naming a beneficiary or by specifically naming the estate, means delays and additional costs to your beneficiaries. It's always better to name individuals as beneficiaries.
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Special rules for spousal beneficiaries
If you are married, the first choice for your IRA beneficiary should be your spouse. Why? Spousal beneficiaries enjoy special benefits non-spousal beneficiaries don’t have.
Spouses have two primary options as beneficiaries (there are others, but these are the most used):
- Keep the IRA as an inherited account
- Roll it over to his/her own IRA (spousal rollover)
Rules for spousal inherited IRAs
If the deceased spouse is under age 70 ½ and the spouse keeps the account as an inherited IRA, there is no RMD (required minimum distribution). The first RMD starts when the decedent would have been age 70 ½ (.
Let's say a wife inherits an IRA from her husband who was 62 when he died. She does not have an RMD for another 8 – 8 1/2 years, which is when the deceased husband would have turned age 70 1/2 (see Rules and Deadlines for Required Minimum Distributions (RMDs)).
If the deceased spouse was over age 70 1/2 when he/she died, the surviving spouse must continue the RMD after the spouse's death. RMD's cannot be rolled over. If the deceased spouse had not yet taken the RMD for the current year, the inheriting spouse must take that distribution before the account title changes. The good news is she gets to recalculate their life expectancy to her own using the IRS single life expectancy table. In most situations, that extends the RMD for a longer period of time.
Rules for spousal rollover
In a spousal rollover, the inheriting spouse takes a distribution of the IRA funds in one of two ways – via direct or indirect rollover. In a direct rollover, the spouse never receives the money in her own name. Rather, the funds go directly to the spouse's IRA account at the same or another institution.
In an indirect rollover (often called the 60-day rollover), the opposite occurs. The company that holds the deceased spouse's IRA cuts a check made payable to the spouse and sends the money to her. She then has 60-days to get the money into an IRA account in her name at another institution.
If she fails to do that within the 60-days, the account value becomes fully taxable in the year received. If she's under age 59 1/2, an additional 10% early withdrawal penalty applies. This can be a costly option. The beneficiary spouse would pay taxes on the full amount of the transferred IRA for the year he/she received the money (to learn more, read When Transferring Retirement Accounts, Which is Best – a Direct or Indirect Rollover? ).
There is no time limit to complete a spousal rollover. In many cases, a younger spouse may wait years to complete the task. A spouse inheriting an IRA at age 40 might wait at least until he/she reaches age 59 1/2. After that age, withdrawals are not subject to the 10% early withdrawal penalty.
Choosing the best spousal option
If the spousal beneficiary is under age 59 1/2, the best option (in most cases) is to use the inherited IRA. If the deceased spouse turns 70 1/2 before the beneficiary spouse reaches age 59 1/2, they would need to take an RMD. However, owners of inherited IRAs aren't subject to 10% early withdrawal penalty. Spousal beneficiaries can do a spousal rollover from an inherited IRA at any time.
After reaching age 59 1/2, transferring funds to a spousal IRA makes sense. Once in the spousal IRA, it's as if the spouse always owned the IRA. Hence, RMDs begin when he/she turns 70 1/2, not the deceased spouse. Keep in mind that once this rollover is complete, it is irrevocable. You can't change your mind. Make sure to consider all of the factors before doing the rollover.
A spouse who is much younger than their deceased husband can keep the inherited IRA as long as they need to. If they are age 40 when their spouse dies, waiting until reaching age 59 1/2 (19 – 20 years) is a perfectly fine option. It doesn't matter how many years it is before he/she turns age 59 1/2.
As with many things with the IRS, rules for IRAs are not simple. If you are someone who does your own planning, the IRS Publication 590-B (2017) is a site you should bookmark and refer to often. Not following the rules is costly. How costly? Missing a required minimum distribution will cost you 50% of what you should have taken. Not the difference in what you took and what you should have taken. It's 50% of the required amount. That is one of the stiffest penalties the IRS imposes.
With IRA beneficiaries, not following the rules might the funds don't get to the people you. Poor decisions may also restrict the options for your beneficiaries, including the option to utilize a stretch IRA. A stretch IRA is a way for beneficiaries to extend their distributions over longer life expectancies.
What do you think? Are you confident you know the rules? Are you sure your IRA and retirement account beneficiaries are up to date?
If you would like to review your beneficiary designations or have questions about what to do, I'd welcome the opportunity to have a conversation with you about it. Go to my online calendar and find a time for a 15 – 30-minute call. You can also complete this contact form with a question.
Please let me know what you think in the comments below.