Importance of Beneficiaries on IRAs and Other Retirement Assets

Working and retired Americans now often hold the lion’s share of their financial assets in tax-deferred retirement accounts, such as IRAs, 401(k)s or 403(b)s.  Spouses, children and grandchildren can inherit such accounts, too.  It is important to consider where the accounts go when the current owner dies, whether it an account created by the owner, or one the owner inherited from a family member.  Having no beneficiary when the current owner dies can lead to unforeseen consequences, both in terms of who gets the financial assets and how much tax is due.

In general, workers can set aside untaxed earnings in tax deferred, “traditional,” Individual Retirement Accounts (“IRAs”) and other, employer-sponsored taxed deferred accounts authorized by Sections 401(k) or 403(b) of the federal Internal Revenue Code.[i]  The worker who owns the account can name one or more beneficiaries to receive the remaining balance in the accounts, when the original owner has died.  Without a beneficiary, often the account will be part of the deceased worker’s probate estate with all tax due in one year, or the account might, under some state’s laws, pass automatically to the surviving spouse.  The first scenario is never good, and the second may not match the wishes of the person who earned the money in the first place.  How may these problems be avoided?

The answer is to name beneficiaries by working with the company holding the account.  Who should not be named?  The most frequently named beneficiaries who should not receive the retirement account outright are minor children, as that would trigger the need for a Court-supervised guardianship over the funds for the minor: costly and cumbersome.  Capable adults are good choices, such as adult children or a spouse.  In some cases, the custodian of the funds will require that the surviving spouse sign a notarized waiver if not named as the beneficiary.

What happens when the wishes of the owner change, either due to divorce or distancing from the original beneficiary?  If the beneficiary designation is not changed after such occurrence, the original beneficiary will frequently receive the account, even if that was not the owner’s wish.

The importance of updating beneficiary designations on retirement accounts is something we discuss in our estate planning meeting with clients, since a majority of people’s wealth is often in those accounts.  A Will or Trust will have no effect on where the retirement assets go in most cases; it is the beneficiary designation that controls.

What about naming a revocable Trust as the beneficiary of retirement assets?  This can be a brilliant idea, or a disaster.  On the disaster side first: revocable Trusts without the exact directions required by the IRS, and beneficiary designations that do not name the specific section of a Trust for an individual person as beneficiary will likely cause the designation to fail, as the IRS will not consider the Trust, generally speaking, to be a “qualified beneficiary.”  On the brilliant side, if the intended individuals are not capable of handling significant assets, either because they are too young (“minors”) or because they are terrible managers of money, then naming a specific subsection of a revocable Trust, which contains all the IRS-required language, can result in the beneficiary being able to get the benefit of the retirement account, managed by the Trustee of the Trust.  The effectiveness of this maneuver requires coordination with both an estate planning attorney and the custodian of the retirement account in addition to having the Trust be a “qualified beneficiary.”

So, this season, when you check your smoke detector batteries, also check the beneficiaries of your retirement assets, and, if they no longer reflect your wishes, speak to an estate planning attorney and the custodian of your account to get the right beneficiaries listed.

[i] As of the writing of this article, the “Secure” Act, “Setting Every Community Up for Retirement Enhancement,” passed the U.S. House of Representatives, but has been stuck in the Senate due to some individual holds by senators.  If enacted, this bill would make changes to the laws to make it easier for workers to start and contribute to tax-deferred retirement accounts.  It would also do away with the option for those who inherit such accounts to “stretch” them out to be paid over the lucky heir’s lifetime, reducing the pay-out time (and the time to pay the taxes on the distributions) to five years.

By: Elaina Hoeppner and Katherine B. Miller, Esq.