By S. Joseph DiSalvo, ChFC®, and Marie L. Madarasz, AIF®
When it comes to your retirement accounts, do you know who your beneficiaries are? These types of accounts have complex distribution rules and significant tax implications for those who inherit them. This complexity is compounded if there are errors or missing information on your beneficiary forms, as is often the case. Add to this the game-changer SECURE ACT, the largest retirement legislation that has been passed in decades—and there has never been a more important time to review your beneficiary forms.
When was the last time you requested a copy of your named beneficiaries from the various institutions that hold your IRAs, 401(k)s, 403(b)s, etc., to check for errors and to make updates if needed? For many people, naming beneficiaries happens when they first set up their account(s). Few give it much thought after that. The courts are full of cases where the family dynamics have changed, but the beneficiary form never did, leaving chaos, disappointment, expensive legal fees and massive tax implications in their wake.
Although most people can get their hands on other important documents such as wills, trusts and life insurance policies, few can put their hands on a copy of their retirement accounts’ beneficiary forms. This is astounding when you consider that most people have saved the bulk of their wealth in these accounts! Many account holders are unaware of how important the beneficiary document is or what the consequences would be if the information is incorrect or is lost. Many people are often surprised to hear that wills do not cover these accounts! They pass outside the will and are distributed pursuant to the beneficiary designation form provided by the financial institution holding the asset, meaning this form trumps other estate planning documents.
If your IRA, 401(K), 403(b) or 457(b) is left without a designated beneficiary, then there is a very good possibility that it will be paid to your estate. When this happens, IRS rules dictate that the account has to be fully distributed within five years if the account owner passes before their required beginning date (April 1 of the year after they turn age 72), potentially causing a huge tax liability to your heirs. If there are no named beneficiaries and the account owner passes on or after the required beginning date, then it could work out more favorably from a tax perspective depending on several different factors.
Do yourself, and your family, a favor. Ask for a copy of your listed beneficiaries from every institution where you have your accounts. Don’t assume they have the correct information you originally provided to them. To avoid mistakes, check the forms and make sure all beneficiaries are named and designate not just the primary beneficiary(ies) but secondary or contingent beneficiary(ies) as well, and clearly outline their percentage of share. Make sure it adds up to 100%. There should be no doubt as to who gets what! Review these forms upon any life changes, such as a marriage, divorce, birth of a child, death of a loved one.
The SECURE Act has changed the rules of the game for anyone who passes away after 2019. Failure to understand the changes and how they will impact your beneficiaries could end up causing upward of 87% of your hard-earned money to go towards taxes!
For example, assume your adult child inherits your million dollar IRA. He/she as a non-spouse designated beneficiary has most likely lost the “stretch” IRA option, and under the new rules will have to empty out the account within 10 years after your death. This may be during their highest earning years and any distributions from this account could potentially push them into the current highest tax bracket of 37+%. If they fail to keep track of the 10-year deadline and fail to “empty” the account in that timeframe, any remaining balance would be subject to a 50% penalty plus income taxes. Combined, 87%, and this does not factor in state taxes.
What Changed with the SECURE Act
For retirement accounts that are inherited after December 31, 2019, there are new rules in place that will require immediate review of beneficiary designations:
1) The SECURE Act has created multiple “classes” of beneficiaries, each with their own set of complex distribution rules. Make sure you understand the definition of each class of beneficiary and the impact the new rules will have on your loved ones.
2) With the passage of the SECURE Act, many trusts that were named as beneficiaries of IRAs/retirement plans will no longer work as originally intended. It is imperative that if you have a trust named as a beneficiary that you have this reviewed and most likely amended or scrapped altogether.
3) The SECURE Act has killed the stretch IRA for most non-spouse beneficiaries. What this means is that most (there are some exceptions) non-spouse beneficiaries will need to “empty” the IRA/retirement account within 10 years rather than “stretch” out their distributions over their lifetime. If they fail to empty the inherited IRA/retirement plan within the new distribution rule timeframe, they will face a 50% penalty of the amount not distributed and taxes due.
Luckily, there are alternatives to the stretch IRA that current account owners can consider. By doing pro-active planning during your lifetime, you may be able to help your beneficiaries keep more assets and leave the IRS with less. Some of these strategies include Roth conversions, tax-bracket management, life insurance, and charitable remainder trusts. However, stop and get advice from a qualified financial advisor, CPA, and/or an estate attorney as the devil here is in the details.
The bottom line: For many people, the beneficiary form is their most important estate planning document, yet most do not periodically review it. With pre-tax retirement accounts containing more assets than ever before along with the recent enactment of the SECURE ACT, it’s never been more important to review your beneficiary designations to ensure your assets transfer according to your wishes and in the most tax efficient manner.
About the authors: S. Joseph DiSalvo, ChFC, and Marie L. Madarasz, AIF
S. Joseph DiSalvo, ChFC and Marie L. Madarasz, AIF, authors of Income for Life, a Retiree's Guide to Creating Income from Savings, are experts specializing in all aspects of Retirement Income Planning, including the coordination and integration of their clients' income, investment and tax planning strategies. They are strong advocates of financial education, seeking to teach others how to achieve sustained success and lifelong prosperity. www.IncomeForLifeBook.com