The Importance of Retirement Plan Beneficiary Designations

Among the financial housekeeping items that are important to review periodically are the beneficiary designations on your retirement plans. Let’s examine the following hypothetical scenario that vividly illustrates why this is so important.

Holding hands

$1.4 million IRA

A husband had been previously married and had children from that earlier marriage. Before he passed away, he had visited an estate planning lawyer and discussed his wishes for having his IRA, with a market value of about $1.4 million, pass entirely to his second wife and upon her death to his children. The estate planning attorney proposed writing a trust specifying that his wife have access to the money during her lifetime with the kids getting the remainder of the trust account after she dies.

However, the trust was named as the beneficiary of the IRA and not the wife. With $1.4 million in this IRA, the implications of naming the trust as sole beneficiary rather than the spouse are very simple: Taxes.

When a person is a beneficiary, they have the choice of what to do with IRA money. They can, for example, liquidate an IRA and take the money, but doing so creates a taxable event. In this hypothetical case, the individual’s $1.4 million became taxable as soon as it passed from the IRA to the trust. Tax-wise, a far, far smarter thing would have been to keep the $1.4 million in a tax-deferred IRA. The wife could have simply transferred her husband’s IRA to an IRA in her name. The transfer would have been non-taxable.

Unfortunately, that’s not what the estate planning attorney did. He named the trust as the beneficiary and not the individual’s wife by name. Once you designate a beneficiary and then pass away, there are typically no ifs, ands or buts about it. Your most recent designation becomes the beneficiary of record. In this case, the trust became the beneficiary, making payment from the IRA to the trust a taxable event.

Saved: $650,000 in taxes

When her husband died, the wife asked what would happen to the IRA money. She thought that she was the beneficiary and that the money would be moved to her IRA. She wasn’t aware that prior to his death her husband had changed the beneficiary designation, on the advice of the lawyer, to the trust. Eventually, the custodian of the husband’s IRA confirmed that the wife was not the beneficiary. The money was going to be taxable.

It was suggested that the individual contact their lawyer to see if the beneficiary change could be undone. Perhaps she could go to the IRS and explain their objective and show that things had been executed in a mistaken way. The attorney declined, saying that there was no chance of that tactic being successful.

The matter was later discussed with another estate planning attorney. She said that there was a very slim chance that the custodian of the IRA would consider what the husband intended rather than the beneficiary he named. She explained that in all likelihood it wouldn’t work, but that it was worth a try.

The IRA custodian was contacted with the following argument: The trust is the beneficiary. The beneficiary of the trust is the wife. Therefore, since the wife is the beneficiary of the trust, please treat it as if she is the beneficiary of the IRA and allow her to transfer the money to an IRA in her name rather than pay it out to the trust.

The custodian agreed with the argument. It took months, but the $1.4 million was finally transferred to an IRA in the surviving wife’s name. That simple act saved her around $650,000 in taxes.

What should you do?

I always encourage my clients to look at their beneficiary designations. Here are some points to keep in mind:

  • Beneficiary forms should be updated following any marriages, divorces, births or deaths of immediate family members. I’ve heard numerous stories where ex-spouses received money following the death of a former spouse who neglected to update his or her beneficiary information. I’ve heard of situations where one spouse dies, the surviving spouse never updates their beneficiaries, and so upon the second death the official beneficiary is a dead spouse. The money gets paid into an estate, becomes taxable income and the kids inherit less.
  • Beneficiary forms typically supersede what is recorded in a will. Make sure your beneficiary forms and your will match one another.

Updating your beneficiary information is just one part of estate planning. Creating and executing an effective estate plan takes a team of trusted, competent advisors, including an estate attorney, accountant, insurance agent and financial advisor. Because my office understands your personal financial picture we can act as the lead on your team, ensuring your wealth goes where you want after your death. Contact our office to learn more or to schedule an appointment.