If you think a will or trust will ensure that your IRA or 401(k) assets go to the person you want after your death, think again. The beneficiaries you list on these accounts will take precedence over your will or trust, and that means if you're not careful, a big chunk of your savings could end up in the wrong hands.

Proper planning prevents problems

IRA and 401(k) plans that list beneficiaries won't go into probate but instead will pass directly to the beneficiaries. If the beneficiary is a spouse, then the spouse can treat the inherited accounts as if they were his or her own. Non-spouse beneficiaries will have the assets put into an inherited IRA, with the amounts received being dictated by the percentages listed on the beneficiary designation form.

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As a result, if you remarry without changing your beneficiary to your new spouse, your ex-spouse will get a windfall after your death. Similarly, if you listed your siblings as your beneficiaries when you established your accounts and then never changed the beneficiaries to your children after their birth, then your brother or sister will get the money in these accounts, regardless of what your will or trust says. As you can imagine, the list of mistakes people make when naming beneficiaries is a long one.

Two more mistakes people frequently make when naming beneficiaries: 

  • Setting up a trust to keep IRA or 401(k) assets from going to a minor (or a spendthrift at any age), or to protect services for a special-needs child, and then failing to list the trust as a beneficiary.
  • Naming no one as a beneficiary on an IRA or 401(k) plan.

You might think a trust allows you to skip the beneficiary section of your IRA or 401(k) plan, but that's not true. If you don't list the trust specifically as beneficiary, accounts will pass directly to anyone listed as a beneficiary or they'll end up in probate. In both instances, not listing your trust as beneficiary eliminates the benefits you were hoping to achieve when you set up a trust in the first place.

Leaving the beneficiary section blank can be disastrous, because if your accounts end up in your estate, they'll go through probate, which is expensive, delays your heirs' inheritance, and significantly crimps their ability to make the most of inherited IRA tax rules. Specifically, your heirs will lose the ability to "stretch" their inheritance out over their lifetime with an inherited IRA, eliminating the benefits associated with long-term tax-deferred growth. Instead, the IRS mandates that assets held in accounts that wind up in an estate be drawn down within five years of the account owner's death.

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Picking the right beneficiaries

In most cases, choosing your spouse as the primary beneficiary on your accounts is the best strategy, because spouses can treat an inherited IRA as if it's their own.

That means spouses can delay withdrawing money from these accounts until they reach 70 1/2 years old, which is when the IRS's required minimum distributions start. Spouses can contribute money to an inherited IRA, and they can use their own life expectancy when calculating future withdrawals. Importantly, by listing their own beneficiaries on these accounts, the next generation of heirs get the chance to use the stretch IRA strategy.

It's also important to choose contingent beneficiaries. Usually, it's best to make a trust or children contingent beneficiaries, but remember, listing a trust as a beneficiary can be a costly decision at tax time, so make sure you consult with your tax attorney first.

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What else should I know?

Career changes can leave you with multiple accounts, and that can make tracking beneficiaries tough. It may make more sense to consolidate your accounts into one account so that it's simpler to make sure your beneficiaries are up to date. Consolidating also makes it easier for your heirs to set up an inherited IRA after your death, and it reduces the risk that an account will be forgotten.

If you do list a trust as your beneficiary, make sure the trust's language takes into consideration how taxes will be handled. If the trust isn't designed as a conduit or see-through trust, then the IRS will tax required minimum distributions from these accounts at the trust's tax rate, not the beneficiaries' tax rate. In 2017, trusts jump to the highest 39.6% income tax rate after only $12,400 in income.

Also, after you've set up your beneficiaries, make sure your beneficiaries have updated their beneficiaries, too. If you leave your assets to your spouse and they pass away without beneficiaries, then these accounts can still end up in probate despite your efforts.

 

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