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By Craig Adamson

Gone. After 53 years of marriage, Carolyn (I'm not using her last name to protect her identity) was now a widow. Her husband always took care of the finances, including managing their IRAs. They were careful. They saved more than they spent and didn't have any debts. They even met with their estate planning attorney in their early 70s, to update their wills and create a legal plan avoid paying estate taxes. So why did Carolyn have to write a check for nearly $250,000 in estate taxes? They weren't millionaires. And the attorney, the one who said they'd owe no "death tax," charged her $25,000 to settle her husband's estate.

Retirement just got a lot more lonely, and a lot less secure for Carolyn.

How did this happen? Why did this happen? Estate planning attorneys typically don't make this mistake, but they are not always well versed in dealing with the tax rules related to retirement accounts. Financial advisers who offer retirement accounts to their clients need to be familiar with the distribution rules and how they impact their client's income during life. They also need to be familiar with how distributions from these accounts impact the beneficiaries after their client's death.

A Typical Conversation

A typical conversation between an adviser who specializes in retirement planning and a new client anxious about making good choices with their retirement savings goes something like this:

Client: Can you look over my IRA portfolio to see if I have the right investments?

Adviser: Yes, but let's back up a minute. Who is the beneficiary on your IRA account?

Client: My spouse.

Adviser: Are you positive? When was the last time you updated your IRA beneficiary forms? Do you or your IRA custodian have a signed copy of that beneficiary form?

Client: What? Umm... I'm not sure. Probably not for a while. Besides, it's all covered in my will. Now about my investments...

Therein lies a common problem with retirement planning. Clients are often focused on the wrong things. They save for years and years, carefully selecting and monitoring their investments. Some even go to great lengths to limit any type of expense associated with owning the account. Then they die and leave an account already "infested with taxes" (that's an Ed Slott quote) open to additional and often unnecessary taxes before it reaches the intended beneficiaries. While the federal government has been promoting a fiduciary rule in hopes of protecting investors from unscrupulous advisers charging high fees and commissions, the IRS seemingly has no qualms about charging widows and orphans 40% in taxes because a beneficiary designation form is not filled out completely or correctly.

When a husband or wife inherits an IRA from their deceased spouse they have a few options on how they can receive those funds. But before they can inherit those monies and avoid estate taxes, the IRA owner must fill out the IRA beneficiary form with the custodian who holds their IRA. The key here is the owner must do this while they are alive. Once they are dead, the opportunity to update beneficiary forms dies with them.

A Critical Detail

Earlier, Carolyn's IRA nightmare was described in some detail. An important detail that was purposely left out of the story was that her husband had named his "Estate" as his IRA beneficiary. Instead of listing their estate, some people will use this phrase "Per Instructions of My Will." Both of these are terrible choices for beneficiary forms for not only IRAs, but annuities and life insurance as well. Carolyn was his wife. He should have listed Carolyn as his "primary beneficiary" to avoid all this unnecessary heartache and financial devastation.

The Five-Year Rule

In some cases, a person in Carolyn's predicament might be able to get the IRA custodian to agree to let her exercise the so-called Five-Year Rule instead of paying the money out to her husband's estate. By allowing her to use the Five-Year Rule, Carolyn can take out some or all of the money from her husband's IRA over the course of the five years after the year of her husband's death. But the account must be completely emptied by that time. In this scenario, Carolyn would have still owed taxes on those distributions, but she could have controlled the amount and the timing of the distributions over those five years. An even bigger benefit to Carolyn is being assessed the taxes at her personal tax rate (much lower than estate tax rates). This would likely cut her tax bill by 50% or more depending on various circumstances.

Naming Your Spouse Gives Them Choices

Had Carolyn been named as a spousal beneficiary, she would have more flexibility to make the best choice for her to inherit her husband's IRA. Those choices are: lump-sum distribution, roll over her husband's IRA into her own or create a beneficial IRA or inherited IRA.

Lump-Sum Distribution

A lump-sum distribution is often taken by mistake by a beneficiary who thinks they must take out the whole amount. In some cases, they heard that "the IRS will get mad" or "I'll get audited" if they don't take out all the money right away. Yes, there are people who believe this. In a few cases I am aware of a professional adviser such as an attorney, CPA, or financial advisers also believed their client must cash out the IRA within 12 months of the death of the owner. These are people who should be familiar with IRA rules, but apparently were not. While a lump-sum distribution is an option, it is rarely a prudent choice as this choice creates almost as much tax liability as the deceased IRA owner naming their estate as the beneficiary.

Rollover to Her Own IRA

Carolyn was already over 70½ years old (the age when you must begin mandatory IRA distributions, or RMDs, when her husband died. Since she was older than 70½, a rollover from his IRA to her IRA is completely acceptable. Most people find it easier to consolidate accounts after the death of a spouse, but it is not mandatory. Some spousal beneficiaries prefer to keep the accounts separated for sentimental reasons. Keeping them separated also has some practical reasons such as the new owner to name a charity as a beneficiary for some IRA money while listing children or grandchildren as the beneficiaries on the other IRA.

If Carolyn had been younger than 70½, and her husband was older than 70½, she would want to strongly consider making his IRA her IRA. Since he would have already started taking his mandatory distribution after age 70½, treating his IRA as her own would allow her to stop the mandatory distributions until she turned 70½ herself. She could still take money out of her IRA and would owe taxes on those distributions. But she wouldn't have to take money out if she didn't want to or need to do so.

Creating a Beneficial IRA

If Carolyn had been younger than 59½ when her husband died, she would be wise to consider becoming the beneficial owner of his IRA. This would allow her to take money out of the IRA account prior to turning 59½ while avoiding the 10% early withdrawal penalty. Surviving spouses who are younger than 59 ½ should take great care and consult a professional adviser before putting the IRA in their own name as any future distributions prior to age 59½ are subject to that 10% penalty. A 30-year-old beneficiary would have to wait 29½ years to avoid the 10% penalty on any of her IRA withdrawals. Federal and state income taxes on the distribution would be owed, but the penalty would be completely avoided.

If Carolyn had been older than 70½ and her deceased spouse was younger than 70½, she would also want to consider a beneficial IRA. Since he would not be old enough for required distributions, Carolyn could use her husband's life expectancy instead of her own to determine when to start RMDs. If he was only 60 and she was 72, Carolyn could wait 10½ more years before needing to take money from his IRA. She could spend hers down first and allow his to grow.

Avoiding a 50% Penalty

Regardless of whether Carolyn takes her husband's IRA into her own name or she becomes the beneficial owner, she must remain diligent about removing her RMD for each IRA account prior to Dec. 31 of each year. She could either take the RMD from each respective account, or have all of the respective RMDs calculated and totaled. She could then take all the total of all the mandatory distributions from a single IRA account of her choice. If she failed to satisfy this tax rule, any amount not taken out by the end of the calendar year is subject to a 50% penalty, plus the income tax on the amount not distributed.

(In a follow up article, I'll will review the rules and strategies for inheriting an IRA from a non-spouse such as a friend, a sibling or a grandparent.)

Carolyn and her late husband did many things very well with their finances over the years. But had they known more about the power of a properly completed beneficiary form for their retirement accounts, they would avoided this catastrophe. While Carolyn's finances were badly damaged, she was able to maintain her lifestyle. There just wasn't as much money to leave their kids as they had planned. But what if someone who was not as well off made this same mistake? Not everyone can afford a 25%, 40%, 50%, or greater loss to their retirement savings.

Whether on your own, or with the help of a qualified adviser, you should regularly review your beneficiary designations. Have you named a primary and secondary (also known as a contingent beneficiary) for each of your retirement accounts? Do you have a signed, dated copy of that form? Does your adviser have a copy, too? And more importantly, does the custodian have the original or a copy of that form on file? What is it worth to you, your spouse, and your family to find out?

About the author: Craig Adamson is a partner at TrueWealth Stewardship; a member the Ed Slott Master Elite IRA Advisor Group -- an organization of financial advisers dedicated to the ongoing study and mastery of advanced IRA financial planning strategies; an Empowered Wealth ambassador; and local board member in both NAIFA and SFSP. Securities and Advisory Services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. Financial planning offered through True Wealth Stewardship, a Registered Investment Advisor and a separate entity from LPL Financial.