Many federal employees and retirees own IRAs, both traditional IRAs and Roth IRAs. IRA owners are advised to name a beneficiary of their IRA, ideally when the IRA is first opened. Naming an IRA beneficiary on a beneficiary designation form is extremely important because the IRA beneficiary form controls who receives the IRA assets upon the death of the IRA owner. This is true regardless of the IRA owner’s family makeup or the intent expressed in the IRA owner’s Will or Trust.
In order to ensure that bequeathed IRA assets best benefit loved ones, the following common mistakes when naming IRA beneficiaries should be avoided:
Mistake #1: Failing to review IRA beneficiary designations on a regular basis
An individual’s life changes quickly. An outdated beneficiary designation form can result in the failure to consider a new spouse or a child or the passage of inherited IRA assts to someone too irresponsible to manage the assets. Most estate lawyers recommend the review of beneficiary designations every few years, or after any significant life event (marriage, divorce, birth of a child, or the death of a loved one). A regular review of one’s IRA and other retirement plan beneficiaries (such as the Thrift Savings Plan) is highly recommended for IRA owners and retirement plan participants .
Mistake #2: Naming one’s estate as beneficiary
An IRA and retirement plan beneficiary should be a person or a trust benefiting a person in order for the potential heir to take advantage of valuable federal tax deferrals such as a spousal rollover or a10-year payout of the IRA/retirement plan proceeds. If the IRA/retirement plan owner’s estate is the beneficiary, then the IRA /retirement plan account will usually have to be paid out in full within one year, most likely at unfavorable income tax rates.
Mistake #3: Not naming a contingent beneficiary
If an IRA owner names a primary beneficiary who predeceases the IRA owner, then if a contingent beneficiary has not been named, the probate court will likely have to determine who should receive the IRA assets in accordance with the IRA owner’s Will or Trust. If the IRA owner does not have a Will or Trust, then the IRA owner’s state of residence default inheritance plan will determine who inherits the IRA assets. Naming a contingent beneficiary prevents the unnecessary costs, delay, and stress of probate. It also allows the IRA owner to control over who inherits the IRA assets.
Mistake #4: Naming a minor child or grandchild as an IRA beneficiary
While there is no law that prevents naming a minor child or grandchild (someone younger than age 18 in most states) as an IRA beneficiary, a financial institution (bank, brokerage or an insurance company) cannot pay benefits directly to a minor. If a minor is designated as beneficiary, then a custodian or conservator will need to be appointed by a state court to manage the inheritance until the minor beneficiary reaches age 18 or 21, depending on state law. In order to avoid any unnecessary legal fees and administrative expenses, IRA owners are advised to ask their estate attorney whether to establish a Trust for the minor’s benefit, or designate that the minor to benefit from the IRA owner state’s Uniform Transfers to Minor Act (UTMA) (or in some states, Uniform Gift to Minors Act (UGMA)).
Mistake #5: Naming one child as IRA beneficiary to share the inheritance
It often occurs that one child is more financially responsible than other children. However, a child may face negative income or gift tax consequences when making a gift of the inherited IRA asset. A child is also under nonlegal obligation to share the inherited IRA assets. An IRA owner with multiple children beneficiaries is advised to ask his or her estate attorney how to appropriately name the children as IRA beneficiaries. Appropriately in the sense of bequeathing inherited IRA assets in the fairest and least problematic manner. For benefiting a child who is not financially able to manage an inheritance, a suggestion is for the estate attorney to create a Trust. See mistake #6.
READ: Costly Mistakes of Inherited IRAs
Mistake #6: Naming young or financial irresponsible beneficiaries
If naming an IRA beneficiary to inherit IRA assets is unwise due to the financial irresponsibility of the beneficiary, then an estate attorney should be asked to create a Trust specifically designed to manage the IRA assets for the beneficiary. In addition, the Trust should put some limits on how IRA assets will be used. For example, the Trust document will state that inherited IRA assets be used to provide for health, education and support.
Mistake #7: Naming a beneficiary with special needs
It is common for a parent to name a child with special needs as an IRA beneficiary. In so doing, the parent may disqualify the child from receiving government assistance, such as Supplemental Security Income or medical benefits. An estate attorney should be consulted to determine whether it is wise to name a Special Needs Trust as beneficiary. A Special Needs Trust should ideally allow inherited IRA assets to pass to a child with special needs without jeopardizing the child’s access to government benefits.
Mistake #8: Beware of the effect of divorce on IRA assets
Some states have laws that revoke provisions for IRA beneficiaries who are ex-spouses. However, beneficiaries for qualified retirement plans, including 401(k), 403(b) and 457 plans, cannot be revoked. This is because qualified retirement plans are governed by federal law; in particular, ERISA. As a result, married couples who are divorcing are advised to complete new beneficiary forms.
Naming the right IRA beneficiaries and updating beneficiary designations as life events occur should be part of every federal employee’s and retiree’s estate plan. Because estate laws vary from state to state, employees and retirees are advised to seek the services of an estate attorney in their resident state in order to develop and implement a proper estate plan. Naming the right beneficiaries for IRAs, qualified retirement plans and the Thrift Savings Plan (TSP), pension plans, life insurance policies, bank, credit union and brokerage accounts is an essential part of a complete and proper estate plan.