Eight Beneficiary Designation Mistakes to Avoid

Beneficiary designation mistakes are among the most frequent causes of estate and retirement plan problems, yet they are easy to avoid. The beneficiary designation, not your will or living trust, decides who inher- its retirement plans, such as IRAs and 401(k)s, and some other assets.

Too of- ten, someone has a well-written will and living trust but the same diligence isn’t applied to beneficiary designations. Beneficiary designations often are made when an IRA or other retirement account is opened and can be changed any time the account is open.

Not long ago, I would refer to the beneficiary designation form. Those forms still exist, but now benefi- ciary designations often are made and changed online or over the telephone. With no forms to review, beneficiary designation mistakes could be more like- ly now. Beneficiary designations should be reviewed regularly with the rest of an estate plan. Here are the beneficiary designation mistakes made most often. Not naming a beneficiary.

An IRA or other retirement account normally avoids probate and passes to the desig- nated beneficiaries separately from the probate estate.

When there is no designated benefi- ciary, the policies of the IRA custodian or other retirement plan administrator determine who inherits the account Often, the IRA is passed to the estate of the deceased IRA owner and then goes through probate. The terms of the will determine who inherits it next. Depending on how your will is written, the IRA might or might not end up with those you intended. There also are negative tax conse- quences to not naming a beneficiary.

Unless the surviving spouse is the sole beneficiary of the estate, the IRA must be distributed within five years after the owner passed away. That is the least favorable treatment of an inherited IRA. It is likely to increase the taxes paid on a traditional IRA, reducing the family’s after-tax wealth.

Not being specific. It’s common to name “my children” or “my grandchildren” as the primary beneficiaries of an IRA or other retirement account. That’s effective in most states, but it’s not the best action. Suppose an IRA owner marries and both spouses have children from previous relationships.

Do the new stepchildren share the IRA equally with the other children? If the couple divorces or the other spouse passes away, do the stepchildren still inherit? Of course, if there’s an unacknowledged child from a previous relationship the situation is more complicated. Often an expensive court action decides who inherits the IRA in these situations. It’s best to name specific indi- viduals as the beneficiaries.

Not updating the designation. I regularly see cases in which a retirement account is inherited by someone the IRA owner likely didn’t intend. Sometimes the designation wasn’t revised after a divorce. An ex-spouse inherits 10 or more years after the di- vorce instead of the IRA owner’s children or current spouse.

Or a sibling inherits because the IRA owner was single when the beneficiary designation was made and didn’t update it after marrying and having children. Another scenario is the ex-spouse of an adult child inherits part of the IRA. In these cases, the courts almost uni- versally conclude that a valid beneficiary designation determines who inherits the account, even if the IRA owner’s will and other evidence indicate that wasn’t what was intended.

Anytime there’s a change in your family circumstances (marriage, divorce, birth, death, estrangement) review your beneficiary designations and determine if they should be changed. Not having contingent beneficiaries. Sometimes a primary beneficiary passes away, and then the IRA owner passes away before updating the designation.

Other times, a good strategy to increase the family’s after-tax wealth is for the primary beneficiary to disclaim inherit- ing the IRA so that other family mem- bers inherit it. For these reasons, you want to name contingent beneficiaries. They inherit the IRA when a primary beneficiary already passed away or disclaims the inheritance. Without at least one contingent beneficiary, the IRA could be inherited by either the IRA owner’s estate or the primary beneficiary’s estate.

That could cause the IRS to go through probate and accelerate income taxes on it. Not having a signed spousal con- sent form. Federal law states that a current spouse can’t be disinherited from a retirement account without giving signed consent. Suppose the IRA owner is in a second marriage and has children from the first marriage.

The children are named the beneficiaries of the IRA. The children won’t inherit if there isn’t a signed con- sent form from the current spouse. The surviving spouse will inherit regardless of what the beneficiary designation says, and the surviving spouse will be able to name the next beneficiaries. The chil- dren of the original IRA owner might receive nothing. Not monitoring the official designa- tions. IRA custodians and plan custodians undergo changes. They are sold or merge.

They change their systems or move. Sometimes during these changes, the beneficiary designations are lost or inad- vertently altered. If a designation is made using paper forms, be sure to keep copies. Label older forms “obsolete” or something similar. Have the current form readily available so your beneficiary or executor can establish your intent. Check online designations regularly, especially after there has been a merger or other change involving the custodian.

Not considering charity. When your estate plan includes contributions to charity, making those contributions through a traditional IRA could be the tax-wise thing to do. When a traditional retirement ac- count is inherited, beneficiaries are taxed on the distributions just as you would have been. They really inherit only the after-tax amount. But most other assets are inherited tax free. In addition, when assets were held in taxable accounts and appreciated while you owned them, inheritors in- crease the tax basis to current fair market value. They can sell the assets with no capital gains taxes due.

There’s no similar step-up in basis for IRAs or other retire- ment accounts. When a charity is the beneficiary of part of a retirement account, the charity doesn’t owe income taxes on the distributions because it is tax-exempt. The estate also doesn’t owe any income taxes, and it receives a deduction from the federal estate tax for the amount the charity receives. It’s better for your family to inherit assets other than traditional retirement accounts while donations are made by naming charities as IRA beneficiaries. Not considering the nature of bene- ficiaries. IRAs and other retirement ac- counts are inherited without restrictions. The beneficiary can take immediate distribution of the account and spend it all.

Or the beneficiary can make bad investment decisions. A huckster could take advantage of the beneficiary. A surviving spouse who inherits can roll over the account to a new IRA and designate new beneficiaries. That might be important when the original IRA owner has children from a previous marriage or doesn’t want the IRA to be inherited by a subsequent spouse of the surviving spouse.

When any of these issues is a concern, consider working with an estate planner to name a trust as the beneficiary.

Your spouse or children would be beneficia- ries of the trust, but the trustee would control how the money is invested and distributed. The trust terms would deter- mine who is next in line to inherit. But naming a trust as IRA beneficiary can have adverse tax consequences. It is important to work with an experienced estate planner who knows how to mini- mize the tax consequences.