How to Protect Your IRA Beneficiary Correctly

by Neal Frankle, CFP ®

Now is the time to protect your IRA beneficiary. Why is now the perfect time?

Two reasons. First, you’re still alive. Once you’re gone, the IRA beneficiary rules you ignored can’t be undone. (Being alive has its advantages sometimes.)

Second, it’s tax season and you are probably going to contact your IRA custodian to make contributions. So while you’re at it, why not make sure everything is set up properly?

In order to make sure your IRA beneficiary form is filled out correctly, you need some background. If you have a family trust (or, heaven forbid, a will), don’t kid yourself. In most cases, they are no use to you when it comes to selecting your IRA beneficiary.

You see, tax-deferred accounts have their own beneficiary designations. Those designations supersede the beneficiaries you name in your trust or will. Let me give you an example to illustrate the point.

Let’s say you get sick and tired of your husband playing the ponies instead of paying the bills, so you divorce the slob. After the divorce, you update your trust but forget to update your IRA beneficiary form with your IRA custodians. If you pass away, your IRA still goes to your ex – and shortly thereafter, probably to the people who own the race track.

So in the worst case scenario, the money you worked hard for could end up in the wrong hands. Even if you are very lucky, failing to name the correct IRA beneficiary could result in that person having to wait a long time to get her hands on the dough.

Also, mistakes made here could force your IRA beneficiary to pay taxes on the money years and years before they would otherwise have to. That means your mistake would cost them big bucks in lost tax-deferred earnings.

Now that I think about it, I have a tragic story to share with you that illustrates the importance of naming your IRA beneficiary and filling out your IRA beneficiary form correctly. This case came up only a few months ago.

Dan, a divorced man, was dying of cancer and had only a few months to live. When he divorced his wife, he named his minor children as his IRA beneficiaries. He died but his wife got control of the money anyway.

How?

Simple…the kids were minors. The ex-wife was the kids’ guardian, so she got to call the shots with “their” money. They had no control. This is an extreme example of how wrong things can go, but it still illustrates the importance of being super mindful when it comes to your IRA beneficiary forms.

Let’s look at more mundane situations and the alternatives you have when naming your IRA beneficiary.

Let’s say Dan isn’t divorced but happily married. He can name his wife as beneficiary, and she can roll the money to an IRA of her own when Dan dies. As a result, she can continue growing the money and deferring the tax under the same rules that govern her own IRA money.

Let’s assume instead that Dan’s kids were over 18 and they are the beneficiaries. When they inherit Dan’s money, they could take it all out whenever they want to. But they have the opportunity to continue growing most of the money tax-deferred as well.

If they do not want the money they will still be forced to take some money out – regardless of their age – but it’s not much. Basically, if anyone other than a spouse inherits an IRA, they must take distributions the year after they got the inheritance.

The amount they must withdraw is determined by their age – the younger they are, the less they have to withdraw. You can get the schedule by reviewing the IRS Publication 590.

How could the IRA beneficiary still lose out?

If Dan named his estate as beneficiary, the money would have to be withdrawn much faster – probably over five years. And in this case, the money would go to the beneficiaries of the estate. Of course, that would entail legal fees, court costs and delays PLUS eliminate the benefit of continued tax deferral. It’s just about the worst of all worlds.

Wait…there is a situation that’s even worse.

That’s if Dan fails to name any beneficiary. Again, this situation would have to be resolved with lawyers and courts. It would needlessly consume lots of time and money. Avoid it…OK?

Now, let’s get back to Dan’s real situation and consider using a trust as a beneficiary. Normally, I would never recommend naming a trust as an IRA beneficiary. But if your beneficiary needs special protection, like they did in Dan’s case, the trust might be the way to go. If that’s the case, speak to your attorney or consider using Legal Zoom to set up your special trust.

Using an IRA beneficiary trust gives you more control. For example, even though the kids are minors and still under their mother’s control, an IRA beneficiary trust can name anyone to be the trustee. This way, the ex-wife doesn’t end up with the money.

There are downsides to using an IRA beneficiary trust. It costs money to set up and you can lose some of the tax deferral time.

In Dan’s case, the trust would have been the way to go. His kids would have had a few years less to continue the deferral, but it would not have been significant. In exchange, they would have been able to keep their mother’s paws off the loot. A good trade-off for Dan and the kids.

Even if you think you have your IRA beneficiary forms set up correctly, do yourself a favor and confirm it. I further suggest you do this every five years. If the children are old enough, discuss your elections with them. It’s a great way to teach kids about money.

Do you have any IRA beneficiary horror stories to share? When is the last time you checked to make sure your IRA beneficiary forms were completed correctly?

 

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{ 8 comments… read them below or add one }

Evan March 9, 2010 at 12:08 PM

That’s HORRIBLE JOE! Was the woman a client? Was the brother an eventual client?

Reply

JoeTaxpayer March 9, 2010 at 5:43 PM

Evan – no. It came to my attention after the fact, the deceased was a friend of a friend. When the gal told me this, I immediately asked how long ago the withdrawal was made. It was past the 60 day period.

I hate finding out after the fact. If the guy was risk averse, I’d have counseled him (on the phone as he was far away) and explained that IRA does not have to equal Stocks. He could have rebalanced to his comfort level, maybe just laddered CDs, and taken those withdrawals as RMDs.

Reply

JoeTaxpayer March 9, 2010 at 11:27 AM

I have a bad story
http://www.joetaxpayer.com/on-my-death-please-take-a-breath/
A woman passes and leaves her IRA to her brother, who is living on just Social Security disability. The IRA value is $160K. He knows nothing about finance, but panics and withdraws all the money. Gets hit with a $40K tax bill. Had he taken withdrawals over his lifetime he may have had almost no tax at all due each year.

Reply

LeanLifeCoach March 8, 2010 at 7:06 PM

And we wonder why the general public doesn’t take care of these things?

Honestly, I think I am going to have to pull all that paperwork out again and double check it.

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Neal@Wealth Pilgrim March 8, 2010 at 11:26 AM

Right you are….yes……VERY interesting concept.

Reply

Neal@Wealth Pilgrim March 8, 2010 at 8:42 AM

Hmmm……but the code calls for beneficiary RMD’s…..so how would it work if the Trust prevents the RMD and the law requires it?

Reply

Evan March 8, 2010 at 8:46 AM

The way I always explain it is:

The trust is a box and inside the box is usually a checking account and the IRA. So you are 100% correct the IRA would have to pay out the RMD but instead of handing the RMD to the beneficiary it would move it into the checking account

Pro: MUCH more control
Con: You are dealing with Trust income rates which are compressed so increased tax.

Reply

Evan March 8, 2010 at 7:44 AM

This topic is SO important! Especially in light of the Supreme Court’s recent case, DuPont.

There are two main types, Conduit and Accumulation (they may have different names accross the Country in Cali). So the eventual decedent could even have the choice to prevent ANY rmd going out of the trust until a Trustee allows for it.

Great Post!

Reply

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