Few people understand the importance of their IRA beneficiary designation forms, because if they did, they’d read the fine print and that might give them pause.
Reviewing these forms should be standard practice for advisers, said Seymour Goldberg, a Jericho, N.Y.-based attorney, certified public accountant and author of “JK Lasser’s Inherited IRAs: What Your Family Needs to Know” (John Wiley & Sons Inc., 2008).
“It’s the most client-friendly service you can perform,” agrees Andrea Wasser, associate counsel at The Vanguard Group Inc. in Malvern, Pa.
WHO GETS WHAT
Clients often neglect to specify the size of each beneficiary’s share of the IRA. This can end up being extremely expensive for the survivors.
A favorite horror story of Ed Slott, tax accountant and author in Rockville Centre, N.Y., is about a mother who listed six children as her IRA beneficiaries, but neglected to add the words “equal shares.” As a result, the IRA custodian decided the first child was the primary beneficiary and the others merely contingent beneficiaries. (The first child emptied the IRA, paying more than $240,000 in taxes, and shared the remainder with siblings.)
Ms. Wasser said Vanguard addresses this issue by stating in its form that if the IRA owner doesn’t specify the percentage of the account that goes to each beneficiary, it will be divided equally among them.
BOILERPLATE IS CRUCIAL
It's not just the fine print that trips up the unsuspecting. Some people don’t even complete their beneficiary designation forms.
“I once discovered a client had listed only a few of his children as IRA beneficiaries, leaving out the others because there wasn’t enough space on the form to list them all,” Mr. Goldberg said. “He thought that it didn’t matter because they were all named in his will.”
This is a common misconception. In fact, however, individual retirement accounts aren’t probate assets. It’s the beneficiary form — not the will — that determines who gets this money. “In essence, the canned language in this form acts as a will for your IRA assets,” Mr. Goldberg said.
The forms vary from one company to another, but not surprisingly, their language is primarily intended to protect the IRA provider rather than the IRA owner and his survivors. This can have unanticipated consequences for the client’s family.
Here’s an example of the most frequent problem: Joe Smith names his three adult children, Bill, Karen and Fred, as his primary IRA beneficiaries. A few years later, Joe Smith and his son Bill die together in a car crash. What happens to Joe’s IRA?
In many cases, it would be split between the two surviving named beneficiaries, Karen and Fred — leaving nothing for Bill’s kids because it’s not unusual for IRA beneficiary forms to mandate “per capita” distribution after the owner’s death. That means the IRA is divided between the surviving named beneficiaries. (From the provider’s viewpoint, it’s easier to split Joe’s IRA between Karen and Fred than to verify the identity of Bill’s kids.)
By contrast, “per stirpes” distribution requires that a deceased beneficiary’s share be divided among his or her surviving children. Naturally, that’s what most clients think will happen. (Indeed, it’s such a universal preference that state laws assume that in a will, all bequests to the testator’s descendants are per stirpes, unless the will specifically says otherwise.)
The Vanguard Group Inc. of Malvern, Pa., and its major competitors list per stirpes distribution in their standard IRA beneficiary forms, said Ms. Wasser, but per capita distribution language in these forms isn’t uncommon.
Some advisers recommend that clients simply add the words “per stirpes” to their beneficiary forms if they aren’t already there. But Ms. Wasser advised against making any changes without first ascertaining that they will be honored. “A company that doesn’t already offer per stirpes distribution in its standard form may not have a process for administering it,” she said.
WHEN TO SPLIT THE IRA
Some advisers have suggested that clients can avoid these pitfalls by simply splitting one IRA into several identical accounts and naming a single beneficiary on each. But some providers don’t offer that option. Vanguard took it off the table a year ago.
In practice, it’s not a good solution, Ms. Wasser said. Maintaining identical accounts takes a lot of administrative work, she said. (For example, the client must carefully alternate among them in taking annual required minimum distributions.) “It was an option used by a very small minority of our clients, many of whom hadn’t understood that they could have several beneficiaries on one IRA,” Ms. Wasser added. But she said advisers should make sure that the IRA provider is prepared to establish a separate inherited IRA account for each beneficiary after the client’s death. “When multiple beneficiaries inherit an IRA, we encourage them to set up their own individual accounts,” Ms. Wasser said.
Lynn Brenner is a weekly columnist on personal finance for Newsday, and has been a business journalist for over 25 years
For other IN Retirement columns visit InvestmentNews Retirement Center.
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