What Beneficiary Designations mean and why they matter
For most people, “estate planning” means drafting documents (such as a Last Will and Testament) that makes sure that your property is managed and distributed according to your wishes. Drafting documents is the foundation of estate planning, but people who own retirement accounts, life insurance or other assets with beneficiary designations must go one step further. When you die, the assets in your estate generally fall into one of two categories: probate property or non-probate property. Probate property is governed by your Last Will and Testament. Non-probate property, however, passes outside of your Will, and generally passes to a beneficiary named by you when the account or contract was opened.
The most common examples of non-probate property are your IRA, 401(k) or life insurance. These types of assets are non-probate property because they are paid to beneficiaries pursuant to a contract that you create when you open the account or purchase the policy. So long as you name a beneficiary, your Will does not control their distribution. Whomever you name as the beneficiary receives the proceeds without having to participate in the probate process.
This post provides some food for thought as to who should be the beneficiary of your IRA. 401(k)s and life insurance can be addressed at a later time. Picking a beneficiary for your IRA may seem like a simple and unimportant matter; but here are four tips that can help you pick your IRA beneficiary.
1. Naming your estate as beneficiary can be a bad idea
Your IRA is not probate property, but, if you want, you can still designate your estate as the beneficiary and your IRA will to be distributed according to your Will. While this seems like a straightforward solution, it can cause some serious problems.
The purpose of an IRA is to defer tax on the money you put into the IRA until that money has had a chance to grow over the course of many years.
The IRS allows an IRA beneficiary (i.e. a real person) to spread out distributions from an inherited IRA over the life expectancy of the named beneficiary. Therefore, the distributions are taxed over the course of the individual beneficiary’s lifetime instead of all at once. Thus, if you name a 30 year old as your beneficiary, and that individual is expected to live another 45 years, they could spread out the forced deductions from the IRA over 45 years. This means that the beneficiary could avoid taxes on the IRA while simultaneously earning interest from the IRA.
Your estate, on the other hand, is not a person, and thus has no life expectancy. Generally, if your estate is named the beneficiary of the IRA, the IRA must be fully depleted within 5 years. Thus, your beneficiaries may lose important long term tax savings if they are forced to take everything within a short 5 year period. Plus, the forced deductions make the IRA earn less over those five years. Therefore, your beneficiary would get taxed at a higher percentage while also earning less if your estate is the beneficiary of your IRA.
2. Store your beneficiary form in a safe place, and make sure your beneficiary knows where the form is stored.
Your beneficiary designation form does no good if no one can find it. A basic excel spreadsheet listing your IRAs, retirement plans and life insurance and the named beneficiaries can be a great way to keep up with your beneficiaries. If you prefer paper, an investment in a small fire-proof filing cabinet is a great place to store your beneficiary designation forms (and other estate planning documents). Safety deposit boxes are not good places because it can be very difficult for someone to access a box that is not their own. In fact, the very document that someone may need to access your box may be……..in your safety deposit box. No matter where you store your beneficiary designation forms and other estate planning documents, make sure that your Executor and Trustee know where they are and how to get access to them.
3. Name a “backup” beneficiary in case your designated beneficiary dies before you do.
As any practicing estate planning attorney will tell you, it is imperative you have a backup (and possibly a backup for a backup) for key pieces of your Will. While it is natural to think you will die before your children, or even your grandchildren, sadly that is not always the case. If your designated beneficiary dies before you, the IRA will look for another beneficiary named in the IRA. If it cannot find an alternate beneficiary, the IRA will pass into your estate, and we know from Tip #1 that is a problem. Therefore, although it is extremely unlikely you will need more than two, it is a good idea to name several backup beneficiaries just to be safe.
4. Do not name too many beneficiaries at once!
If not having a backup beneficiary is bad, having too many beneficiaries at one time can often be worse. The IRS will force distributions out of the IRA based on the age of the oldest named beneficiary. Therefore, if you have your spouse and your children each listed as a beneficiary, the IRS will force distributions based on your spouse’s projected remaining life expectancy. While this may not be a problem if your spouse is relatively young, it will still limit the lifetime tax benefits your children could have enjoyed had they been named sole beneficiary.
Therefore, it can often be a good idea to split the IRA into multiple accounts and name each person individually as the beneficiary of that new, smaller account. This allows that beneficiary to maximize their lifetime tax savings. It also may allow your spouse to roll the portion of the new account created for them into their own IRA, which further increases their lifetime tax deferment benefits.
Patrick R. Norris, J.D., Norris Legal, L.L.C.
Thank you for reading this article. The information contained in this article is for discussion purposes only. The information contained in this article is not legal advice upon which you should act and simply reading this article does not make you a client of Norris Legal, L.L.C. or any other law firm. Thank you again.