It's Not Just a Matter of Common Sense: Why it pays to name contingent beneficiaries for your IRAs2/17/2017 In my last post, I explained the importance of naming a beneficiary in your IRA, and how it can have major income tax and growth consequences for a child that is the named beneficiary. So now the question is about naming contingent beneficiaries, or backups so to speak. If you're thinking to yourself, it's not so much a question, really -- it makes good sense to name contingent beneficiaries in case the worst happens to your primary beneficiary, you're right. Most people quickly realize that they might as well name a contingent, as there's no downside to it (other than imagining for a second the awful prospect of having a child predecease you).
But, what many don't realize is that there can be tremendous upside to doing so, even if the child you named as your primary beneficiary outlives you. Wait -- you thought that a contingent beneficiary designation only kicks in if the primary beneficiary dies? Not true. A beneficiary has the ability to disclaim what is left to him (whether it's an asset left in a will or an IRA) and have it flow down to the next-in-line. To be clear, that ability is limited - specific documents must be filed and approved within limited time frames. But having that ability can be a powerful tool in estate planning. Let's revisit the scenario of Rose, who thankfully by now is the named beneficiary of her mother's IRA. Rose is fortunate; she lives comfortably, has sufficient savings and has planned well for her own retirement. She is not in a situation where she is relying upon all of her mother's money. She also has two teenagers. Let's say that Rose's mother names her two grandchildren as the contingent beneficiaries of her IRA. When Rose's mother passes away, if Rose decides that she is comfortable with the idea of not receiving that IRA money herself, she can disclaim some or all of it, and the disclaimed portion of the IRA would then pass to her two children as contingent beneficiaries. This is where the concept of the IRA "stretch" comes into play -- the difference is that Rose's life is now bypassed in the calculation for the disclaimed amount. So instead of the IRA's required minimum distributions being stretched over 50 year-old Rose's life expectancy, they are now stretched over the life expectancy of teens. The translation: decades more of tax-free growth with smaller required distributions and lower tax bills on the distributions. Is this to say that disclaiming an IRA is the right thing to do for everyone or that your grandchildren should be your contingent beneficiaries? Not at all. Every situation is different. But just having that option can be such a potent wealth-building tool that it underscores the need to treat IRAs as a very important aspect of estate planning, discussed in depth with your attorneys to maximize their potential value and to avoid any unintended consequences. Finally, you know the saying about the best laid plans...as a practical matter, despite everyone's intentions and the best legal minds at work, the effectiveness of these beneficiary designations often comes down to whether the particular financial institution holding the IRA and processing the beneficiary paperwork is going to treat those designations the same way you would have expected when the time arises. So I will say this: these institutions have inheritor services departments dedicated to handling estate work. Why wait to make use of those departments until there is an estate and then be faced with an unfortunate surprise once it is too late to change anything? You could make inquiries now, during the planning phase -- ask them how they would handle the different scenarios you are contemplating. Peak Executor Solutions LLC does not render legal advice. The content of this article is for general information only. It is not intended to provide specific advice or recommendations for any individual.
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A Rose by any other name would smell as sweet?Not when it comes to naming your IRA beneficiary.1/22/2017 Last week, my friend Rose called me. She was visiting her 80-year old mother, when her mom got a call from an advisor at the financial institution that holds her IRA account, telling her it was time to take her annual distributions and that she should really name a beneficiary. My friend asked me to shed some light on the phone call. Your mom is 80, I explained, and ever since she turned 70 1/2, she's needed to take what are called minimum required distributions on her IRA. So she would have to do that this year, too, and the amount of the distribution increases each year as she gets older. But, are you telling me she has no beneficiaries listed? Yes, my friend said. My mom just figured it would go to her estate and then go to me in the same way her will gives the rest of her estate to me as her only child. Well, that's true, I explained -- since your dad passed away a long time ago, leaving it to the estate would get it to you, ultimately. BUT, that will also come with some major income tax ramifications to you and really hurt the growth potential of those funds.
This is a mistake that is commonly made. And, it really underscores how little many people understand about their IRAs, how they function over the long term, and how small mistakes like this have big consequences. So let's back up. Most IRAs are tax-deferred investments, meaning that the money that went into them were from pre-tax dollars and that income tax will be due upon withdrawing money from the account (not so with Roth IRAs). IRAs are attractive retirement vehicles for good reason: since you don't first have to pay income tax on the money going in, you can sock away larger amounts even early in your career, and watch all that money grow and compound tax-free for decades. When you turn 70 1/2 years old (although there is some ability to defer until the April 1st of the year that follows the calendar year you turn 70 1/2), you are required to start taking annual minimum distributions that are calculated based on your life expectancy. Those distributions are then taxable as income to you as the recipient, subject to your income tax rate at the time the distributions are made. Keep this point in mind - I'll come back to it in a minute. IRAs have their own beneficiary designation forms. If you've ever had a job where you've participated in a retirement plan, you may remember your HR department having you fill out a form like that when you started your job. You may have wondered why the HR person was intent on tracking you down for that form. That is because for an IRA to function the most effectively and reap the greatest possible benefit, you need to have beneficiary designations on file with the financial institution that is the custodian of the IRA. Now, back to the income tax issue. As I mentioned, Rose's mother has to take minimum required distributions each year. Because those distributions are based on her life expectancy (that is, in turn, based on actuarial tables), the amount she has to withdraw each year as minimum distributions are going to be a relatively large percentage of the IRA's principal for a woman who is 80, and that amount is all considered taxable income. Now let's say Rose's mother properly filled out her IRA beneficiary form, naming Rose as the beneficiary of her IRA. If she passed away, then as the IRA's beneficiary, then the assets in the IRA would transition into a beneficiary IRA account for Rose. Rose would then have to start taking minimum required distributions (just as her mother had) within the calendar year following the year of her mother's death, except that, instead of calculating the distributions based on her mother's life expectancy, the distributions are now calculated based on Rose's life expectancy. In other words, the denominator in the calculation increases. Given that Rose is 50 years old, that translates to two things: (1) smaller distributions, and (2) decades' more worth of growth in the IRA principal. Smaller distributions mean a lower income tax burden when the distributions can be spread out over a longer period of time, particularly when a 50 year-old might be in the highest tax bracket she will ever occupy. This is what is commonly referred to as the IRA "stretch" -- the ability to stretch the minimum distributions over a longer life expectancy. Let's contrast that now to a situation where Rose's mother failed to name beneficiaries or named her estate as the beneficiary. Under this scenario, her will (naming Rose as beneficiary) would lead the IRA to be distributed into a beneficiary IRA to Rose, but now the entire landscape of the distributions becomes vastly different. Under this scenario, the IRS rules say that Rose's beneficiary IRA must be fully distributed within 5 years of her mother's death. While the distribution can happen all at once or in parts, all of it must be completed within 5 years. And it can lead Rose to lose money in three different ways, which is ironic, considering that her mother was trying to leave everything to her. First, the five-year distribution rule can translate to a very hefty income tax bill for Rose in a short period of time, and she will have to come up with the cash to pay that tax bill. Second, that additional income from the rush of distributions within five years might even bump Rose into a higher tax bracket, which is certainly not the result that Rose anticipated -- now she not only has a large tax bill for the IRA distribution, but also has a higher tax bill on all of her income. Third and finally, in failing to have specific beneficiaries designated for the IRA, her mom unwittingly killed the IRA's stretch potential, taking away what could have been decades of tax-free growth and a significant legacy for the daughter to whom she wanted to leave everything. Look for my next post -- It's Not Just a Matter of Common Sense: why it pays to name contingent beneficiaries in your IRA. Peak Executor Solutions LLC does not render legal advice. The content of this article is for general information only. It is not intended to provide specific advice or recommendations for any individual. |
Sheri HametzFounder, Peak Executor Solutions LLC ArchivesCategories |