A married couple pays a local attorney to draw up estate documents. The attorney drafts wills and lays out the well-conceived plan for testamentary trusts to be created upon death, distributing assets just as the husband and wife desire. The couple signs the documents with appropriate witnesses and goes home to the relief that their estate plan is finally in order.
Unfortunately, their relief is ill-founded. Nearly all of their financial assets are held in 401(k) and IRA accounts and they did nothing to address the beneficiary designations. This hypothetical couple made the all too frequent mistake of assuming that their will or trust would govern distribution of their retirement accounts when these accounts are instead governed by beneficiary designation forms (in addition to any life insurance contracts, annuities, and POD/TOD accounts).
The mistake of ignoring the beneficiary designation is only one of several frequent mistakes when it comes to retirement plan beneficiaries. Below, we cover 11 common mistakes that people make when naming beneficiaries and why they have the potential to cause major problems.
1) No named beneficiaries
Perhaps the worst possible mistake you can make is assuming other estate documents will cover retirement account distribution and thus not naming any beneficiaries. In the case in which no beneficiary is named, beneficiaries are appointed by a state probate court which could result in unintended results as well as unnecessary legal costs. Additionally, the eventual beneficiaries do not benefit from the ability to stretch distributions over their respective lifetimes as distributions are forced over an accelerated period. [i]
2) Your estate or last will and testament as beneficiary
Regardless of how well drafted your will may be, naming your estate or “last will and testament” as beneficiary has the same result as not naming a beneficiary when it comes to the unfriendly payout terms. Additionally, when the retirement account goes through the estate, it becomes subject to all creditor claims – something that would be avoided if a beneficiary was named.
3) Minor beneficiary
Children under age 18 or 21, depending on the state, are prevented by law from owning legal property of any kind in their own name. IRA and 401(k) custodians are similarly prohibited from dealing with minors. Resultantly, naming a minor outright as beneficiary has two potential problems. First, the court must appoint a guardian to handle the retirement account(s) until the child reaches the age of majority. This can create an unintended outcome and unnecessary legal costs. Second, the minor beneficiary obtains outright ownership of the retirement account(s) at age 18 or 21. For small retirement accounts, this may not be an issue. For individuals who have accumulated a healthy 6- or 7-figure balance in retirement accounts, making these funds immediately available to a child upon their 18th birthday without constraints is often not in the child’s best long-term interest.
4) College age beneficiary
A child who has reached the age of majority can legally inherit an IRA. Yet for reasons mentioned above, a child or children in their early 20’s may not be in a good place to receive a large inheritance. The fact that the average inheritance is spent within 18 months is the very reason that most parents use a trust to distribute large inheritances over time to young adults rather than outright.
5) Ex-spouse as beneficiary
You set up a retirement plan 25 years ago and named your then husband, now ex-husband, as beneficiary. Without a change to the beneficiary form, the 25 years of savings to a retirement account is slated to go to your ex-husband regardless of what your new will says.
6) No contingent beneficiary
Consider the case where a husband and wife name each other as primary beneficiary when first opening a retirement account but fail to ever name contingent beneficiaries. In the event of a simultaneous death such as a car accident, the Uniform Simultaneous Death Act provides that the beneficiary is deemed to have died first. Without a living primary beneficiary or any contingent beneficiaries, this is again the equivalent of not naming any beneficiaries.
7) Special needs individual as beneficiary
Leaving IRA assets to a special needs family member or friend who is receiving needs based government benefits could cause the individual to lose these important benefits. A better way to plan for such persons is to create a special needs trust or supplemental needs trust and name the trust as beneficiary of the retirement account. The trust assets can then be used to supplement government benefits rather than eliminate them.
8) Not naming a trust as IRA beneficiary for asset protection
A 2014 Supreme Court ruling found that inherited IRAs, unlike IRAs that you establish and fund on your own, are not protected from creditors in bankruptcy. Individuals with large IRA balances worried about asset protection of inheritors now have good reason to consider using a properly drafted trust as IRA beneficiary.
9) Naming a generic trust as beneficiary
A trust can be useful as an IRA beneficiary for several reasons, many already mentioned: creditor protection, divorce protection, spendthrift concerns, minor beneficiaries, and special needs beneficiaries. However, a trust that fails to qualify as a “look-through” trust by meeting the four criteria outlined in the Internal Revenue Code, creates several undesirable results. A common way that trusts may fail to qualify for look-through status occur when the oldest beneficiary is not identifiable in the trust. Boilerplate trust language that provides power of appointment to the beneficiary or names a charity as one of the beneficiaries can trigger this problem. As a result of not qualifying for look-through treatment, the trust faces the same unfriendly distribution schedule as if no beneficiary were named.
10) Naming a charity as beneficiary for a Roth account
When you contribute to a Roth account or convert existing Traditional IRA/401(k) assets to a Roth account, you are paying taxes on income today to avoid taxes in the future. Leaving Roth assets to a 501(c)3 charity that pays no taxes simply means that you paid unnecessary taxes. The better solution is to leave other assets to the intended charities or not convert/contribute to the Roth in the first place.
11) Elderly parents as beneficiary
People without children occasionally name their parents as primary beneficiaries and then siblings as contingent beneficiaries. The problem with this planning is that the IRS mandatory distribution schedule is forever based on the age of the initial beneficiary. Naming a 90-year old parent (or any elderly person) as primary beneficiary destroys most tax benefits of the retirement account because the IRS forces distribution over a short period (the 90-year old’s life expectancy). Elderly persons may be the desired choice as beneficiary but it pays to consider the unfriendly tax ramifications before making this choice.
The key takeaway is that beneficiary designation forms are often a hugely important but overlooked piece of good estate planning. It’s wise to review your designations on a regular basis and check with your financial planner or estate attorney to decide if any changes are appropriate.
Did we miss any common beneficiary designation mistakes? We welcome you to share them in the comments section below.
[i] If the decedent was under age 70 ½ and not yet taking mandatory distributions, the full distribution is required over five years. If the decedent was over age 70 ½ and had already begun required minimum distributions, then the distributions can be based on the IRS life expectancy of the decedent or the five year period, whichever is longer.