Retiree Portfolio IRA Beneficiaries Remain Important

Whom you select -- or fail to select -- to inherit your IRA assets will have a significant impact on the tax burden to your heirs. For that reason, it's important to review your IRA beneficiary selections periodically to ensure those choices meet your wishes. Recent changes to IRA distribution rules have simplified beneficiary planning for IRAs, so it's easier now than ever.

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By Dave Braze (TMF Pixy)
October 29, 2001

When is the last time you really looked at your IRA? Oh sure, from time to time you may revisit your investments to see if a change is needed, and given the recent market drop that's probably particularly true today. But when is the last time you really did a thorough and objective review of your other elections since opening that arrangement with your IRA provider?

According to the Investment Company Institute (ICI), mutual funds held some $1.2 trillion in IRAs in 2000. The ICI also tells us that, as of May 2001, 42% of U.S. households owned an IRA. The median balance in those household accounts was some $30,000 for traditional IRAs, $6,000 for Roth IRAs, and $48,000 for employer-sponsored IRAs (SEPs, SIMPLEs, SARSEPs). Clearly, then, there is some serious money in those accounts. And I assume that you, like me, share in that ownership.

Questions: What happens to the money in your IRA should you depart this world prior to spending it all? Do you remember whom you chose as a beneficiary when you opened your IRA? Does that choice still reflect your wishes? Are you sure that your beneficiary designation is on file with your provider?

If the answers to these queries fail to spring immediately to mind, then it's time for you to review how you've handled that aspect of your retirement and estate planning. We highlighted this problem some time ago in an earlier article. Additionally, we examine some of the issues involved in "Designating IRA Beneficiaries." Recent changes to IRA minimum required distribution (MRD) rules make choosing a beneficiary easier, so there's no better time than the present to get your estate in order. What you do in this area has a significant impact on the overall income tax burden to your heirs.

An IRA may be left to anyone. When you open the account, you must complete a beneficiary designation form. That's where you name the lucky person or persons who will get your stash after you are gone. This important form governs what happens to the account when you die. And, like life insurance proceeds, on your death your IRA balance will flow to the persons named on that form.

Therefore, whatever you say regarding the disposition of the IRA in your will doesn't matter. Your provider will distribute the IRA proceeds based on the beneficiary designation form you completed. If you have a named beneficiary, that heir can take payments of the IRA balance over his or her remaining lifetime. But if no one is named to receive the account balance, then what's left in your IRA normally must be distributed to your estate no later than the fifth year following the year of your death. If you had begun MRD prior to death, though, the remaining balance can be paid to the estate over a period of time based on your life expectancy  (calculated as of the year of death) as if you were still alive.

Most of us will name a spouse as our IRA beneficiary. That's fine because a spousal beneficiary has great flexibility in what to do with the IRA. He or she may keep the IRA in your name or elect to transfer the proceeds to an IRA of his or her own, and then name a new beneficiary for that IRA. But what happens to your IRA if your spouse predeceases you or if you have since divorced?

If you name your spouse as your beneficiary but he or she dies before you do, the IRA would flow to the person you named as the secondary or contingent beneficiary. Without an alternate beneficiary in place, the IRA provider must pay the balance to your estate. That result would provide your heirs with few options. If you named your spouse as your beneficiary but have since divorced, unless you took steps to change your beneficiary designation your ex winds up with the moola.

The loss of a primary beneficiary due to divorce or death highlights the importance of two things: reviewing your choices periodically, and naming a secondary or contingent beneficiary at the time you designate the primary. In the first instance, by completing a new beneficiary election form, you can name a new primary beneficiary as well as a new secondary or contingent beneficiary. In the second case, if you die before making a change based on a primary beneficiary's earlier demise, the secondary or contingent beneficiary (such as a child) will automatically get your IRA balance as desired.

Equally important is ensuring your IRA provider has the beneficiary designation on file. Errors happen, and they can be costly. The financial press often cites the dire results of what can happen when the IRA provider has "lost" that critical form. In one case cited two years ago by The Wall Street Journal, a lost beneficiary form caused the hapless sole heir to the estate to take an immediate payout of the IRA instead of a lifetime distribution. As a consequence, she lost more than $1 million in potential growth she might have had by taking a lifetime payout of those proceeds.

How do you avoid that terrible result? Two ways.

First, make sure your provider has your beneficiary form on file. To do so, just ask for a new form, fill it out, retain a copy of the completed form for your records, and then return it to the provider by certified mail, return receipt requested. Ensure your heirs know where that form and the certified mail receipt can be found after you die. That way, just in case there is any dispute after you're gone, your heirs can prove you gave the provider a properly executed form before your demise.

Second, examine your IRA agreement to ensure the provider will allow heirs other than spouses to take a lifetime payout. Today, most will, but not all. Because your heirs must pay income taxes at their rate on anything they receive from previously untaxed money in traditional IRAs, lifetime payments could lessen that burden significantly. And if you have a Roth IRA, then they can prolong the benefits of tax-free growth over the years, thus "growing" an even larger income during their lives. Consequently, if your IRA provider won't allow that procedure, it's time to think about switching providers.

Need more objective advice about how you can protect your heirs and your family? Want to actually talk to someone about it? Then check out TMF Money Advisor.

See you next week. In the meantime, post away on the Retirement Investing or the Retired Fools boards.

Best to all... Pixy

The Motley Fool may be all about investors writing for investors, but Dave Braze is all about retirement. Much to the relief of his editors, the countdown to his third retirement now stands at 32 days. Maybe he'll get it right this time. We can only hope.