By Robert Klein, CPA
When you die, you want to make sure that your assets are distributed to your intended beneficiaries. The transfer of retirement plans at death is controlled by beneficiary forms associated with individual plans. Beneficiary forms supersede all other estate planning documents. Directly named, or designated, beneficiaries will be the ones who receive the funds.
Beneficiary mistakes can result in retirement plan assets being transferred to unintended beneficiaries. Beneficiary forms for each retirement plan need to be periodically reviewed and confirmed in writing with plan providers in the case of workplace plans and custodians for IRAs.
Post-death changes, if they can be made, are expensive since they generally require litigation or private letter rulings from the IRS. This article discusses five retirement plan beneficiary mistakes you want to avoid.
Mistake #1: No Designated Beneficiary
What happens if no beneficiary is named for a retirement plan such as an IRA? In this situation, the estate may become the beneficiary by default. Plan documents, in the case of workplace plans, and custodial agreements, in the case of IRAs, will determine who receives the plan’s assets.
If the estate becomes the beneficiary, two problems can occur:
1. The distribution of the affected retirement plan will be accelerated.
This can potentially be as little as five years after death if it occurs before one’s required beginning date for taking required minimum distributions (RMDs).
2. The affected retirement plan will become a probate asset since there is no designated beneficiary.
The transfer of the plan would be subject to delay and probate fees, with the latter dependent upon the plan value and state in which the decedent resided. Furthermore, assets may be distributed to unintended beneficiaries.
Mistake #2: Naming Estate as the Beneficiary
The consequences of naming your estate as the beneficiary of your retirement plan are identical to not naming any beneficiary. As discussed above, distribution will be accelerated and the plan will become a probate asset with assets potentially being distributed to unintended beneficiaries.
As a general rule, you should never name your estate as a retirement plan beneficiary. This applies to primary and contingent beneficiaries.
Mistake #3: Not Naming a Spouse as the Primary Beneficiary
The ability to stretch out the distribution of retirement plans over one’s lifetime was significantly curtailed with the SECURE Act. It went into effect on January 1st and applies to all deaths after 2019. The Act still allows for lifetime distributions; however, this applies only to a new category of beneficiaries known as “eligible designated beneficiaries,” or “EDBs.”
EDBs include surviving spouses, minor children, disabled individuals, chronically ill individuals, and individuals not more than 10 years younger than the retirement plan owner. Adult children and grandchildren are not included. Designated beneficiaries who don’t qualify as EDBs are subject to a new 10-year rule whereby retirement plan accounts must be emptied by the end of the 10th year after death.
Assuming that your goal is to maximize the distribution period of your retirement plan assets and you’re married, you should generally name your spouse as the primary beneficiary of each of your retirement accounts. This is required for company plans subject to ERISA unless the spouse waives that right by satisfying the written spousal consent requirements. Although IRAs aren’t subject to ERISA and you aren’t required to name your spouse as your beneficiary, it’s generally advisable to do so.
Mistake #4: Not Naming Contingent Beneficiaries
In addition to naming one or more primary beneficiaries, it’s important to name contingent, or backup, beneficiaries for each of your retirement plans. Failure to do so can result in assets being payable to your estate when primary beneficiaries predecease you.
The best way to illustrate this is with an example. Let’s assume a married couple, John, age 68, and Sarah, age 66, with both individuals owning sizable IRA accounts that originated from 401(k) rollovers. John names Sarah as the primary beneficiary of his traditional and Roth IRA accounts and Sarah names John as the primary beneficiary of her traditional IRA account. Neither one names any contingent beneficiaries.
Sarah predeceases John, and John, as sole primary beneficiary, elects to roll over Sarah’s traditional IRA account to his traditional IRA account. Since John hasn’t named contingent beneficiaries for his IRA accounts, his estate would become the beneficiary if he doesn’t change the primary beneficiary of each account from Sarah to someone else.
As previously discussed, distribution of John’s IRA accounts will be accelerated to five years after John’s death if he dies in the next four years before his required beginning date of age 72 for taking RMDs. In addition, John’s IRA accounts will be subject to probate, resulting in delayed distribution, probate fees, and potential distribution to unintended beneficiaries.
Mistake #5: Failure to Revise Beneficiaries for Life Changes
In addition to John and Sarah being vulnerable to mistake #4, i.e., not naming contingent beneficiaries, John is also exposed to mistake #5 – failure to update beneficiaries for life changes when Sarah died. John can remedy this situation if he changes the primary beneficiary of his IRA accounts from Sarah to one or more other individuals before he dies.
Beneficiary designations for retirement plans as well as life insurance and annuities need to be reviewed periodically and potentially revised for other types of life changes. These include birth, marriage, and divorce. Failure to make desired changes following divorce can be especially problematic, with assets potentially being transferred to unintended beneficiaries, depending upon the type of asset and applicable state law.
Mistakes can be Avoided with Periodic Beneficiary Form Review
Beneficiary forms for each retirement plan should be completed, reviewed periodically, and revised as necessary in conjunction with analysis of applicable current plan documents or custodial forms to ensure that individual plans will be distributed to intended beneficiaries.
Life insurance and annuity beneficiary forms should also be scrutinized as part of this exercise. The completion and review of individual beneficiary forms should include other estate planning documents such as divorce decrees, trust documents, and pre- or post-nuptial agreements for potential conflicts. An estate planning attorney should be retained for preparation of estate planning documents and whenever there are any life changes.
About the author – Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the writer and publisher of Retirement Income Visions, a blog featuring innovative strategies for creating and optimizing retirement income that Bob created in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions focused on each client’s needs.
Retirement Income Center has established relationships with various highly respected professional organizations and platforms to provide the firm’s clients with its comprehensive array of fee-based planning, management, and protection services.