Don't Forget About Your Beneficiaries

What’s your legacy plan?  This is a question that I often ask my clients.  I ask this for many reasons, but the main reason is to get them thinking about what happens when they are not here.  Have they taken care care of their wills, life insurance polices, and for this discussion: retirement plan beneficiaries.  I’ve already shared a few stories on the importance of your beneficiary designations, but I can’t stress this enough.  This time I want to focus on retirement plans- specifically, IRA’s, and 401k’s.

Since their introduction in the early 1970s, Individual Retirement Arrangements (IRAs) and qualified plan assets such as 401(k), 403(b), and 457 plans have become an important component of many investors’ retirement plans. While the intent of these accounts is to supplement Social Security and provide income during retirement, many affluent investors may not need or be able to spend all of the money in their retirement accounts. This creates an opportunity to leave these accounts for the benefit of heirs. This post outlines the fundamentals of beneficiary designations which are important not only in terms of leaving a legacy but also to ensure that estate and income taxes don’t unintentionally consume retirement plan assets. It should be noted that a full discussion of the tax impact of such designations is beyond the scope of this post; investors should seek appropriate counsel prior to making any investment or tax decision.

Tax Considerations

Assets in qualified retirement accounts are considered “income in respect of a decedent”. As such they are includable in a decedent’s estate on which taxes are due within nine months after death. In 2009, the maximum federal estate tax is 45%, and the exemption equivalent amount is $3.5 million. In an estate where the qualified account is a sizable estate asset, depending on who is the account beneficiary (for example a non-spouse which does not qualify for the marital deduction), without advance planning for payment of estate taxes the account might have to be liquidated to pay them. This distribution could in turn trigger an income tax liability to the beneficiaries. (Note that there is an income tax credit available to beneficiaries for estate tax paid.) With proper beneficiary planning, this can be minimized or avoided.

Definition of Beneficiary

As illustrated  below, beneficiaries of qualified accounts are considered to be either “designated” or not. A designated beneficiary is a living person for whom a life expectancy can be calculated. A non-designated beneficiary (called simply a “beneficiary”) is anything else. This is a critical distinction in determining how the assets are paid out of the account.

Designated Beneficiary

A designated beneficiary can be further classified into two types — the spouse and everyone else (“non-spouse”) In some situations, trusts can be considered designated beneficiaries, assuming they are set up correctly.

Spousal Beneficiaries

The account owner’s spouse is usually listed as the beneficiary of the account upon the account owner’s death. In fact, in many cases, the spouse has to approve the designation of an alternative beneficiary. As a beneficiary, the spouse has four options allowed by the IRS:

1. Leave the money in the account.
2. Take a lump sum distribution.
3. Take an annuitized distribution based on their life expectancy.
4. Roll the assets over into their own IRA account.

This last option is only available to a spousal beneficiary, and is often called a “Spousal Rollover”.

Non-spousal beneficiaries

A non-spousal beneficiary could be children, grandchildren, nieces, nephews, or any other living person the account owner chooses. These beneficiaries have three distribution options allowed by the IRS:

1. Leave the money in the account.
2. Take a lump sum distribution.
3. Take an annuitized distribution based on their life expectancy.

Non-spousal beneficiaries cannot roll the account into their own account as a spouse can. One very popular strategy for non-spousal beneficiaries is the third strategy – taking distributions based on life expectancy. This is often called the “Stretch IRA”, and for a child beneficiary they can stretch the distributions into the future for as long as they are expected to live– 30, 40, or even 50 years — depending on their age when the account owner dies.
There are two primary benefits to this strategy:

1. Most of the money remains in the account, and grows on a tax-deferred basis,
2. The beneficiary only pays income tax on the amount that comes out each year, stretching out their income tax liability over many years, instead of having to pay it all at once if a lump sum distribution is taken. (If estate tax has been paid due to income in respect of a decedent, a pro-rated income tax deduction is allowed the beneficiary. Contact a tax advisor for more information.)

Non-Designated Beneficiaries

Non-designated beneficiaries include any beneficiaries for whom a life expectancy cannot be determined, such as non-qualified trusts, charities, and the decedent’s estate. Qualified accounts with non-designated beneficiaries must be distributed either within 5 years of the owner’s death if they die before attaining age 70½ or, if the owner had already attained age 70½ and was receiving required minimum distributions, these must continue until the account is depleted.

Multiple Beneficiaries

It is possible, and quite common, to have more than one beneficiary identified for a qualified account. IRS rules issued in 2002 have made planning for this situation much easier. Beneficiaries now have a “Gap Period” between the date of death of the account owner, and September 30th of the following year, called the “Designation Date”, in which to separate the account for each beneficiary. This provides beneficiaries more flexibility in their planning and the opportunity to take distributions as they wish.

Hypothetical Example of “Gap Period”

For example, if an account listed 3 beneficiaries, two children and a charity, and the accounts were not split before death or during the Gap Period, the account would have to be completely distributed within 5 years of the owner’s death because the charity is a non-designated beneficiary. This would cause an income taxable event for the beneficiaries more quickly than they may have wished. However, if the account were split into three separate accounts, one for each beneficiary, the charity’s portion would go to the charity, and each child would be able to decide how they wanted to have the money distributed, including taking it out as a Stretch IRA, based on their individual life expectancy.

Other Planning Considerations

• Ensure that contingent beneficiaries are named. Beneficiaries cannot be named after the death of the owner/participant, and if the primary beneficiary is dead, and no contingents are named, the estate becomes the beneficiary and the account must be distributed within 5 years.
• Ensure that beneficiary designations are current on all of retirement accounts as changes may be necessary due to births, deaths, marriages, and divorces.
• Coordinate beneficiary designations on all qualified accounts with those listed in their will or in their estate planning documents. Beneficiary designation forms control who legally is entitled to the account, not the will.

photo by .bryan.stupar.

You always think you have everything in order. The will is in place and updated. You just had your trust document reviewed last month. You just verified the stock certificates are in the safety deposit box this week. Wait, did I update my beneficiary on the life insurance policy?

Beneficiary Horror Story

One story that I will never forget was about a client whose mother had just passed away. He was one of three brothers that all got along and equally shared in taking care of the mother. She set up her will so that each of the three sons which would each get a third of her estate when she passed. Everything seemed to be in order, so she thought. Turns out that after her passing  the mother’s annuity had the eldest son as the only beneficiary. The annuity happened to represent 80% of her total estate. Of course, the son, knowing his mother’s wishes, would pass the deserved share to the other brothers, right? Sadly enough, this was not the case. The brother suddenly felt he deserved it because he was the eldest. This of course damaged the family to this day.

Don’t Forget About the Retirement Plans

Annuities are not the only item that could have this fate. Retirement plans from work, IRA’s, and life insurance policies all have beneficiary designations that supersede wills. Naming beneficiaries to these types of accounts is one of those planning activities that is typically given too little thought, however those named to inherit such assets often face unique tax and legal consequences.

Employer-Sponsored Retirement Plans and Individual Retirement Accounts (IRAs)

Regarding employer-sponsored plans, such as 401(k)s, an individual who is not married can name whomever they like as beneficiary. If you are married, however, federal law states that your spouse is automatically the beneficiary of a 401(k) or profit-sharing plan. If you wish to name someone else as beneficiary, then your spouse must sign a written waiver.

For example, someone who has been separated from his or her spouse may wish to name a domestic partner as the intended beneficiary. The spouse still has a legal claim to the 401(k) assets, and the domestic partner will not be able to receive the funds unless the spouse signs a written waiver. A waiver may be appropriate in other situations, such as a second marriage in which children from the first marriage need the money more than the new spouse.

Until recently, one drawback was that nonspouse beneficiaries were not eligible for tax-deferred transfers to IRAs. Instead, these beneficiaries would have to begin taking distributions, on which they would be required to pay income tax. However, rules signed into law in 2006 allow nonspousal beneficiaries to have qualified plan proceeds rolled over into a special type of IRA called a “Decedent IRA” set up on behalf of the beneficiary via a trustee-to-trustee transfer.

The IRS has also issued regulations that dramatically simplify the way certain withdrawals affect IRA owners and their beneficiaries. Consult your tax advisor on how these rule changes may affect your situation.

IRS regulations do allow nonspousal beneficiaries to annuitize retirement plan distributions over the life of the beneficiary. Check with your employer or policy issuer to find out if this is an option under your arrangements prior to naming a child as a beneficiary.

Life Insurance

No matter who is designated as beneficiary of a life insurance policy, he or she will receive the death benefit proceeds income tax free. Unlike property disposed of in a will, if the beneficiary designation form is properly completed, insurance proceeds do not go through probate.

For many married people, a spouse will be the most logical beneficiary. A trust may be a better beneficiary choice, however, if a surviving spouse was not capable of (or comfortable with) managing a large sum of money. In this case, the trustee (often a legal entity rather than an individual) would take charge of managing, investing and disbursing the policy proceeds for the benefit of the surviving spouse.

Be sure to name contingent or secondary beneficiaries. A secondary beneficiary — either an individual or trust — would be next in line to inherit the insurance proceeds if the primary beneficiary predeceases the insured. If there are no surviving beneficiaries, then your beneficiary is generally the “estate of the insured,” which means the death benefits end up being probated and ultimately distributed according to the instructions of the decedent’s last will and testament. If an individual dies without a valid will (intestate), then the order of legal beneficiaries to whom assets are distributed is specified by state law.

Avoid Naming Minor Children

Naming minor children as beneficiaries may cause unforeseen problems. For example, insurance companies and retirement accounts may not pay death benefits to minors. Instead, these benefits are held until they can be paid to a court-approved guardian and/or trustee of a children’s trust or until the child reaches legal age. A guardian, trust or trustee should be named beneficiary to ensure competent management of the proceeds for the children. By naming a children’s trust as a beneficiary, the proceeds could be invested and managed by a competent trustee (a person or institution) you choose. A revocable living trust could also be named as a beneficiary, which keeps the proceeds out of probate.

Keep Your Plan Up-to-Date

When completing overall estate plans and wills, it is important to occasionally review and readjust all beneficiary designations so that your estate plan accurately reflects your wishes. Remember, outdated beneficiary designations (e.g., older parents or ex-spouses) could misdirect the intended flow of an entire estate plan unless changed now.

Securities offered through LPL Financial, Member FINRA/SIPC