Last month we reviewed some differences and similarities between 401ks and IRAs that can create cost and confusion. Yet another difference you and your employees should know about is beneficiary designations. This applies to 401ks, IRAs, insurance policies, annuities, or any account that has a beneficiary.

You would think this area would be straightforward. It’s not (did you expect the tax code to be simple)! It can, and often does, get very complex. I’ll provide some basic guidelines to serve as a starting point for avoiding pitfalls that can result in unintended and costly consequences.

The Importance of the Designated Beneficiary (a person)

  1. Ensures your money goes to who you want it to.
  2. Ensures this tax advantaged money can “stretch” distributions as long as possible. Stretch simply means that your IRA can pass from one generation to the next and maintain tax its deferred growth. Depending on time and account size this can mean millions of dollars of compound growth. It pays to be aware of the rules!
  3. Ensure these assets aren’t forced into probate (with the attendant expense and hassle)

To protect heirs from themselves, more sophisticated estate planning strategies may be explored in lieu of simply naming designated beneficiaries. These plans require an estate planner to prevent heirs from making costly errors, offer asset protection, and allow for the stretch.

Band-Aids Be Damned

Huge sums of money lose tax advantage status every year due to ignorance of tax law. An heir may erroneously cash in or rollover the IRA/401k; or re-title the account incorrectly; or someone forgets to update an IRA beneficiary form after a divorce. Many a second spouse and children have inadvertently been disinherited by a failure to update a beneficiary form. Not the legacy most people have in mind!

Case in point: a 27-year-old grand-child inherited an IRA worth about $400,000. He rolled it into an account in his name instead of doing a trustee-trustee transfer. This is considered a distribution! Fatal error. Because he didn’t follow the rules, he paid tax on all $400,000 in the year he transferred the money.  Consequently, he lost a life-time of tax deferred compound growth. The error cost him multiples of his after-tax inheritance. Millions of dollars. The numbers get even bigger if you extend compounding to another generation.  Ouch. No band-aids or IRS private letter rulings will fix this one.

401K vs. IRA – Some Differences That Are Often Present

  • 401K Plans usually want the money distributed over 5 years after a death (sometimes less); IRAs – generally allow for the stretch (though not all custodians allow for stretch).
  • 401Ks require a spousal waiver if the spouse is not the primary beneficiary; IRAs generally don’t.
  • 401Ks hierarchy of heirs begins with the spouse; IRAs are not standard and could default to your estate, leaving your trustee with probate and applicable taxes to deal with.

 

How to Avoid Unforced Errors

  1. The first thing to know is that beneficiary form designations are the final word on where your money will go upon your passing. Case law is very well established on this point. It doesn’t matter what your intent is, what your estate plan or will says – the beneficiary form rules.
  2. Keep current! Review beneficiary forms periodically (include insurance policies and annuities).
  3. Keep good records.
  4. If you go to work for a new employer, do a trustee-trustee transfer into an IRA or your new Plan.
  5. If you retire, consider moving Plan assets via trustee-trustee transfer into an IRA to ensure stretch potential.
  6. Seek legal, tax, or financial help to be sure you have it properly covered. A more sophisticated set of facts and circumstances implies more need to plan to grow and preserve wealth. The added cost can pay for itself many times over.

 

Jerry Matecun helps business owners to understand and manage retirement plan risks and responsibilities, as well as help participants understand saving, investment, and distribution strategies vital to retirement readiness. For a no cost, confidential conversation regarding your retirement plan call or email Jerry at 949-273-4200, or jerry@compoundvalue.com.