02/21/2015
An IRA (Individual Retirement Account) is a useful estate planning tool that you can use to pass your "fortune" to your heirs without the need for a costly "living trust." There are however pitfalls if you fail to utilize the provisions of beneficiary designation to select the person(s) or entity to receive your IRA proceeds.
It's very easy to forget to update your beneficiary designation when critical life events occur, such as a divorce, simply forgetting to name a beneficiary, or changing them when you desired beneficiaries change. Quite often people simply do not sit down and look at this paperwork because it deals with that major issue, second after taxes, that we all will face some day, our own demise.
You could unwittingly give your spouse that one thing you want to preserve in your divorce, your half of the IRA that you retained when it was divided, by simply failing to change the beneficiary designation.
A divorce, a death of desired beneficiary, or remarriage, are the most frequent events that most people overlook when naming beneficiaries, and which can result in an asset that has grown tax-free going to the wrong beneficiary.
It's important to update and review beneficiary forms after every life event. This should be paired with a period review of all estate planning documents to ensure that your wishes will be carried out by the custodian of your funds. Updating a Will does not affect a distribution from an IRA, only a beneficiary designation can do this.
Failing to remove an ex-spouse after a divorce can have disastrous results, and which could result in your IRA funds being further gifted to someone else's children instead of your own, who may have been minors when you added your then-spouse as a beneficiary.
I routinely require that clients bring me current beneficiary designation forms to verify the intended recipients.
Naming your estate
Many people draft their own estate planning documents online using "inexpensive" tools to save the cost of consulting with an attorney. The result can be costly, as this can deprive an heir of a significant growth opportunity. Normally, non-spouse beneficiaries who inherit a traditional IRA can choose between two options: Either liquidate and pay taxes on those assets within five years of the owner's death, or "stretch" their required minimum distributions out over their lifetime.
By naming the estate as the beneficiary, the testator (creator or owner of the "estate") limits the beneficiaries' ability to stretch the IRA after the owner's death. It speeds up the income taxes on the distributions as well and can amount to hundreds of thousands of lost growth potential.
By failing to name an individual, which would allow the IRA to pass outside of probate, the asset could be considered part of the estate, and used to satisfy debts owed to creditors. Further, your beneficiaries may be waiting for many months for probate to snake its way through a burdened and underfunded court system, thus causing delays.
Name your loved ones, not your estate, and do them a favor and provide them with an opportunity to take advantage of the growth opportunities afforded by an IRA, which continue to grow during distribution periods.
No financial controls
Many simply name their children, who are often not sophisticated enough to invest these funds, or better yet not prudent enough and serve them, and will often withdraw them all paying the penalties squandering them in a short period of time.
Without any "controls" that are available in estate planning vehicles, your beneficiary can spend his or her funds any way they choose, college, a down payment on a home, or a Maserati! Tennessee.
By naming a Trust, and appointing a trustee you can trust, and identifying specific categories for distribution, you can ensure that your heirs will benefit from your wealth by identifying the categories of support that a trustee can fund. Traditional support trusts provide for health, education, welfare. Further specification can assist the trustee by clarifying the type of educational costs that can be funded from trust distributions, to encourage beneficiaries to attend college, university, or even graduate school, which could be funded from trust assets, freeing up your beneficiaries' other resources for their own discretionary spending. Shop for an IRA or annuity that may offer "restrictive beneficiary endorsements" which can replace more costly corporate trustees by limiting or narrowing distributions via specific instructions for distributions. This can preserve the "corpus" or principal of the fund, while distributing income earned, and allowing the fund to continue to grow. By naming a minor child, you could also deplete resources more quickly if it becomes necessary for a probate court to appoint a guardian to hold funds for a minor, which also takes time to be carried out. Worse yet, could be the situation where you name your minor child, only to have your ex-spouse named as the guardian. Also important is the critical process of safeguarding your estate planning papers, to keep them private, while making them accessible to your heirs quickly in the event of an untimely demise. Don't expect that financial institutions, which go through many mergers, buy-outs, and are taken over, have successfully warehoused your paperwork, and can find them when the time comes for them to be reviewed and implemented. This could result in your beneficiaries losing the ability to "stretch" the pay-out, as described above. Most community property states prohibit naming anyone other than your spouse as a beneficiary without a waiver. Discuss these issues with your loved ones. For many who are on their second marriage there can be an agreement to keep benefits in the "family" so that each of you waive your interest in your spouse's pension or benefit plan so you can designate your own children.
Estate and financial planning are lifelong processes that must be monitored, updated, and adjusted as life's predictable crises change our lives, our plans, and our fortunes.
