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IRA Beneficiary Designations
Our law practice settles a lot of estates. The most common, and costly, mistake we see is the incorrect beneficiary designation on IRAs. In the last two months I have worked with two estates where hundreds of thousands of dollars of income taxes will be paid long before they should have. I have written about this issue in the past, but the frequency of these blunders and the extraordinary taxes they trigger tell me there are more ticking time bombs out there. Maybe you can find and defuse them before they go off.
There is an irony in all this. A client can have a complex estate plan with exotic wills and trusts collapse at his death because of a silly mistake on an IRA beneficiary designation form.
Background For many clients their IRA is the single largest asset. IRAs require special attention because they are subject to both estate tax and income tax. Furthermore, the disposition of an IRA at the owner's death is not controlled by his will. The IRA is controlled by beneficiary designation. Remarkably, there are many financially sophisticated clients who are surprised about that.
Unlike most estate planning problems, errors in IRA beneficiary designations are easy to find and fix. Let's take a look at how you should go about this.
Common Errors The common mistakes fall into four broad categories.
First, the IRA names the client's "estate" as beneficiary. This is always a mistake. The estate pays income taxes at rates that are higher than those for individuals. Income is bunched into one or two years. The family has lost the opportunity to stretch out the IRA distributions (and income taxes) over a much longer period. Post mortem tax planning becomes unnecessarily complex and expensive. The client's advisors look bad as disgruntled heirs wonder who screwed up, and the finger pointing starts.
Second, the IRA names no beneficiary at all. By default, in most cases, the "estate" is the beneficiary, so we are back to the first problem noted above. This mistake is often caused when IRAs are transferred by the owner to a new custodian. In the paper shuffle, the beneficiary designation for the new account doesn't get filled out.
Third, the IRA names more than one beneficiary. This can be a problem, especially if one of them is the surviving spouse. The spouse's opportunity for certain minimum distribution options may be limited.
Fourth, the IRA names a trust as beneficiary. This is not always wrong. If the trust is a special "look through" trust qualified under the new IRS regs, that may be the right move. I do lots of those. But, in many cases the trust is not qualified. This most often occurs when a client using a living trust names it as IRA beneficiary on the mistaken belief that "everything" has to pass through the living trust to "avoid probate" and “avoid taxes.” Don't get me started.
Planning Tips Here are some suggestions on IRA designations that can help you avoid the costly pitfalls.
- When in doubt, name the spouse. This "spousal safe harbor" is hardly high level tax planning, but it works. The surviving spouse is the only person who can use a fully income tax deferred rollover. As long as the spouse is a US citizen, the IRA qualifies for the full estate tax marital deduction. I have never settled an estate where naming the spouse created a tax problem. Furthermore, if the IRA also named carefully chosen contingent beneficiaries, there are post mortem tax options available. More on that below.
- Each IRA should name only one primary beneficiary. Use multiple IRAs, each with a single beneficiary, rather than a single IRA with multiple beneficiaries. Multiple IRAs are fine. The additional cost and paperwork during the client's lifetime are insignificant in view of the benefits they provide. At death, each beneficiary is free to make his or her own decisions on distributions and investments. Spousal minimum distribution options are not jeopardized. Some IRA custodians will treat one IRA with several beneficiaries as multiple, individual IRA accounts for each beneficiary after the owner's death. Check that in advance the custodian.
- Use multiple IRAs for the spouse, especially if the spouse is younger than 59-½. The spouse can then rollover some accounts for long term deferral and growth but withdraw funds from others for immediate living expenses without incurring the early distribution penalty. Surviving spouses also have special options for minimum distributions that can be selected for separately for each IRA.
- Watch for Special Situations. If the beneficiary is a minor, or needs protection, the “look through” trust assures long term payouts and tax deferrals with the intervention and supervision of a trustee selected by the client. “Look through” trusts also work well for IRA QTIP elections in the case of second marriages and for credit shelter trusts funded with IRAs if the estate tax is an issue.
- Use the IRA to make charitable bequests. IRA distributions are subject to full income tax. However, if you name a tax exempt charity as your IRA beneficiary, the charity will receive the money but not pay income tax. This makes much more tax sense than naming the charity in a will. This also simplifies the estate settlement, because the charity is not then a probate beneficiary under the will. I recommend that, for convenience, clients set aside a separate IRA that names only charities as beneficiaries. The client can then add to or reduce the IRA balance during his lifetime with tax free IRA to IRA transfers, and the beneficiary designations can be revised at any time before death. The problem of "multiple beneficiaries" does not arise because the charities will all take their share in a lump sum at the client's death.
- Carefully select contingent beneficiaries. A "contingent" beneficiary, or "secondary" beneficiary, is the person who will receive the IRA if the primary beneficiary dies before the IRA owner. The obvious planning reason is the possibility that the primary beneficiary dies before the IRA owner. But, if the primary beneficiary is alive at the owner's death, the primary beneficiary can "disclaim" some or all of the IRA. In that case, the law pretends that the primary beneficiary died before the IRA owner, thereby clearing the path to redirect IRA proceeds to the contingent beneficiary. For example, if the husband dies with his wife as the IRA primary beneficiary and a daughter as contingent beneficiary, the wife can "disclaim" the IRA in favor of the daughter. The disclaimer must be made within nine months of the IRA owner's death, so there is plenty of time for post death tax planning. The new IRS rules on IRA distributions encourage the use of disclaimers. Naming children, or grandchildren, or charities as contingent beneficiaries gives the primary beneficiary tax planning choices. However, the primary beneficiary of an IRA cannot disclaim in favor of only one of several contingent beneficiaries. The primary beneficiary can only disclaim or not disclaim. This means that multiple IRAs, each with one primary beneficiary and one contingent beneficiary, may be necessary to offer the widest possible post death options.
- Move balances out of a qualified plan and into an IRA by tax free rollover as soon as possible. Many clients terminate employment and leave their funds in the company 401(k) plan. That makes some sense, as the client continues to get "free" professional investment management. This has a risk. Most qualified retirement plans provide that the balance be distributed in a lump sum to the named beneficiary at the former employee's death. Employers don't want to incur the expenses of long term payouts if the former employee is deceased. If the beneficiary is a spouse, there's no problem, as he or she qualifies for a tax deferred rollover to an IRA. However, if the beneficiary is not the spouse, such as a child, there can be no rollover. The child gets hit with a lump sum distribution subject to full and immediate income tax.
- Make sure your "durable power of attorney" specifically authorizes changes in IRA (and qualified plan) beneficiary designations. This is critical if the IRA owner becomes unable to act on his own behalf. Under a standard "durable power of attorney" you can add provisions to allow your designee to make IRA beneficiary changes. In this post-Enon, post-mutual fund scandal world, some IRA custodians (or plan administrators) will not allow the appointee under a standard durable power of attorney to make beneficiary changes unless the power of attorney specifically allows it. As another "belt and suspenders" precaution, you may use the "in-house" power of attorney form that most brokerage firms, mutual fund companies, and banks provide for account holders.
- Keep all your IRAs with a single custodian. If you do this, your chances of mistakes greatly diminish. When dealing with a single IRA custodian, or financial planner, or broker, you get the benefit of a "second set of eyes" watching your IRAs. Oftentimes it is the "orphan IRA," the one created by the client years ago that only he knows about, that gets overlooked and has the beneficiary error.
Most of these suggestions are easy to implement with minimal expenses, if any. They will save a lot of taxes after the IRA owner dies.