Three Common Mistakes When Naming an IRA Beneficiary and How to Fix Them

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Despite the fact that retirement accounts can be among the most valuable assets in a person’s estate, they are often overlooked during the estate planning process. Especially if your IRA was initiated by your employer, it may end up a bit “out of sight, out of mind” until the day when you begin taking mandatory distributions.

An IRA account is a tax-deferred retirement account, meaning that you do not have to pay taxes on the income that you save for your retirement. You will, however, have to pay income taxes on those funds as they are distributed to you throughout your retirement. Typically, mandatory minimum distributions from an IRA begin at the age of 70.5 years (this is referred to as the “required beginning date”). Once you reach your required beginning date, you will have to withdraw at least a minimum distribution each year. This minimum amount is calculated using the year-end value of the account divided by your life expectancy divisor, as designated in the IRS Uniform Lifetime Table. The older you get, the larger your minimum distributions become.

You may not remember this, but when you opened your IRA account you likely filled out a beneficiary designation form. This is a standard form that specifies who you want your IRA funds to go to if you die before they have been fully distributed.

Because an IRA is a special, tax-deferred account, there are lots of restrictions on how these accounts can be transferred. An incorrect beneficiary designation can result in the funds going to an unintended beneficiary, substantial tax consequences, and long-term loss of value. This article will go through three common mistakes people make when naming an IRA beneficiary. If any of these situations sound familiar, make an appointment with your estate planning attorney to review your options.

1. Failing to Revisit Old Forms: Who Did I Designate in the First Place?

One of the biggest mistakes that people make with their beneficiary designation is to forget about it. If you have been married, divorced, had children, or lost a loved one since the last time you updated your beneficiary designation, it is time to revisit it. All too often when a person passes away, his or her IRA funds will go to an unintended beneficiary because the designation form was not updated. If you have been divorced recently, it is very likely that your beneficiary designation form names your ex-spouse as your primary beneficiary.

If you cannot remember when you last revisited your beneficiary designation, the best place to start is to request a copy of this form from your financial institution. It is relatively simple to update a beneficiary designation form; however, it is best to have these updates reviewed by your estate planning attorney to ensure they are completed correctly. Failure to complete a beneficiary designation form, or filling it in incorrectly, can create unintended results.

It is important to remember that beneficiary designation forms control, so anyone you list on that form will be the beneficiary, regardless of what you write in your will or in any trust instructions. Make sure to include both primary and contingent beneficiaries in case any of your beneficiaries die or decide not to accept the distributions. Beneficiaries cannot be changed after your death.

Once you have updated your beneficiary designation form, retain a copy for your own records. Keep the form in a safe place and make sure that your loved ones know where to find it after you have passed.

2. Naming Your Estate as Beneficiary: Do Not Miss Out on the Benefits of an IRA

There are a number of reasons why people have IRAs — the tax-deferred benefit is one, but there are also other benefits that are designed to reward retirement savings. By transferring to a named heir by way of a beneficiary designation form, IRA assets stay out of probate. Probate is the process by which the court in your state takes your will (if you have one) and collects all of your assets into one place. Under the supervision of a personal representative or executor, your estate and will are placed on public record and subject to any outstanding debts or challenges to the validity of the will. The probate process is public, expensive, and time-consuming. During the probate process, your loved ones cannot access their inheritance.

If you name your own estate as the beneficiary of your IRA account, or if you fail to designate a beneficiary under certain custodial agreements, the assets that remain in your account will be liquidated into your estate. This triggers income taxes on the total value of the account, eliminates the tax-deferred benefit, and subjects these assets to the public probate process.  Those assets then become vulnerable to creditors, and distributions to your beneficiaries are delayed until the probate process is complete.

3. Maximizing Your Retirement Funds: Take Advantage of an IRA’s Full Potential

If you regularly revisit and update your beneficiary designation form and do not name your estate as the IRA beneficiary, you have already avoided the biggest problems with naming an IRA beneficiary. However, who and how you designate beneficiaries can have an impact on the long-term amount of distributions from the account.

When it comes to beneficiary designation, your options are pretty broad: you can choose one or more individuals, a trust, or a charity. However, each of these choices will have profound impacts on how the IRA funds will be distributed and whether these distributions will allow your IRA to reach its full potential.

When you choose an individual as your beneficiary, this person will either be a spousal or non-spousal beneficiary. A spousal beneficiary may choose to simply “roll over” your IRA funds into his or her own. This will not trigger any early mandatory distributions. If you choose a non-spousal beneficiary, he or she can choose to either cash out the IRA or “stretch” the funds by taking minimum distributions in accordance with their own age.

Taking a lump sum distribution of the retirement account means the entire amount will be taxable upon distribution. This could create a hefty tax burden, and the funds will not be allowed to continue to grow over time. However, a lump sum may still be attractive to beneficiaries who are not financially-savvy or who do not understand the long-term benefits of “stretching-out” an IRA over a lifetime.

The benefit to “stretching-out” an IRA account is that the funds can continue to grow in the retirement account and will be distributed slowly over time. For your heirs, this will also allow them only to pay income taxes on the amounts received each year. Because of the “stretching” benefit, your IRA’s greatest potential value would be realized if you name a particularly young person as your beneficiary, because the funds would be distributed over the greatest number of years. However, a young person may be more likely to choose to take the lump sum. If all of the funds are released at once, there will be an immediate tax burden and the loss of many years of tax-deferred growth.

If you are concerned that a particular beneficiary would choose to take a lump sum rather than utilize the “stretching” benefit, you can choose to name a trust as a beneficiary of an IRA account. This would give you total control over what happens with the assets once you pass. A trust becomes irrevocable upon your death, meaning that whatever you designate cannot be altered.

There are a number of circumstances which might make a trust the preferred beneficiary of an IRA account. These can include if you wish to provide for minor children, if you are concerned that your spouse may not name your children as beneficiaries, or if you want to protect the funds from your heirs’ creditors or poor spending habits. Decide whether control matters to you. The language of a trust can stipulate how the assets should be used and how often funds will be distributed.

If you are going to name a trust as the beneficiary of an IRA account, it will need to be done carefully and it is best to work with an attorney because it can be done incorrectly. An incorrect beneficiary designation can revert to the default in the account agreement or result in unfavorable tax penalties. If a trust does not qualify as a designated beneficiary, it will have a life expectancy of zero, and the assets will be required to be distributed in as little as five years.

Avoid Common Mistakes by Meeting with an Attorney 

Although IRA beneficiary designations are made with a standard, boiler-plate form, the impacts of this form can be significant. Because it is so easy to make a mistake that causes long-term damage to your loved ones, it is important to review your beneficiary designation form regularly and with an attorney who understands your estate planning priorities.

Ask a St. Petersburg Attorney for Assistance

If you have questions or would like assistance with naming IRA beneficiaries to make sure your loved ones are well taken care of when you are no longer here, start by calling our office in St. Petersburg, Florida at 727-537-6818 to schedule an appointment with one of our experienced estate planning attorneys today!

Kira Doyle