You contribute to your retirement plans on a regular basis. You track your growth to make sure that you’ll have a comfortable retirement. But what happens if you die unexpectedly? Do you recall who you chose to be your beneficiaries? And are you sure that your choice is the best way to achieve your goals?
To help us answer that question, we contacted Ryan C. Edwards, CFP®. He’s an investment executive at CornerstoneShreveport.com helping people achieve overall financial success.
Q: What happens if we don’t name a beneficiary?
Mr. Edwards: If you don’t name a beneficiary on a retirement plan or an IRA, the assets in the plan will be probated according to your will. Probate can be a lengthy and costly process, so most people want to avoid probate by listing specific primary and contingent beneficiaries on their retirement plans. The beneficiaries will have almost immediate access to the assets at no additional cost to the estate.
Additionally, by listing a beneficiary, you protect the assets from creditors. If you don’t list a beneficiary, the probate court will consider the assets in the plan part of your estate and subject to creditors.
Finally, if you do not name a beneficiary for your retirement plan or IRA, then you limit the ability to stretch the IRA over the recipient’s lifetime. A non-spouse listed beneficiary can take a lump sum distribution, take the assets out over a five-year period, or take the assets out over a lifetime. The advantage of taking the assets over a lifetime is that it allows for tax-deferred growth and can provide more control over any taxes paid. An unlisted beneficiary (one determined by probate court) can only take the assets by lump sum or over a five-year period, eliminating the lifetime option. This can result in higher taxes on both the assets in the plan and earned income as well as a missed opportunity for growth for the recipient. Depending on the size of the account, hundreds of thousands of dollars of tax-deferred growth could be the cost of not naming a beneficiary.
Q: Can I change beneficiaries?
Mr. Edwards: Yes, you can change beneficiaries on retirement plans and IRAs. However, if you are married in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), your spouse generally must sign off on changing the primary beneficiary to anyone different from him/her.
Q: Am I limited to relatives when choosing a beneficiary? Or could I select anyone?
Mr. Edwards: You are not limited to relatives when choosing beneficiaries on retirement plans (exception noted for spouses in community property states). You can select absolutely anyone; in fact, you can list charitable organizations and trusts as beneficiaries.
Q: What happens if I prefer the money to go to an organization (like my church, the ASCPA, or other non-profit organization)? Can I name them as the beneficiary?
Mr. Edwards: Absolutely. Because the organization is a non-profit, they will not pay any taxes on withdrawals from the retirement plan. Most non-profits will withdraw all of the funds immediately upon receipt.
Q: Can a minor (underage) child be a beneficiary?
Mr. Edwards: Yes, a minor can be listed as a beneficiary, but this is where I caution parents. The most common scenario involves parents who list spouses as primary beneficiaries and their minor children as contingent beneficiaries. By listing minors as beneficiaries, the assets do avoid probate; however, the minor children have access to the funds with no strings attached when they reach the age of majority (18-21 depending on state). Most parents are not comfortable with the idea of an 18-year old having access to a windfall, whether it is from retirement plans, IRAs, or life insurance. Also, if you do want to list a minor child as a beneficiary of a retirement plan or IRA, be sure to list a guardian/custodian of the assets in estate planning documents. Otherwise, the appointment of a custodian or guardian could be a lengthy ordeal requiring probate.
I often suggest meeting with an experienced estate planning attorney and tax accountant to consider making a trust the contingent beneficiary. There are a couple of different types of trusts that could be established. A testamentary trust would be created by the parents’ wills and would receive the retirement plan assets. Because the trust is not created until death, the assets would likely still pass through the probate process.
An unfunded living trust could also be established prior to death and be listed as the beneficiary of the retirement plan. The primary benefit of having a living trust is that the plan would avoid probate; however, the cost of setting up and maintaining the trust has to be taken into account. Again, an experienced estate planning attorney can really help parents make informed decisions.
Q: Is there a reason that I wouldn’t want money going to my adult children?
Mr. Edwards: Definitely. If your adult child is a spendthrift or is a poor manager of money, then you may want to consider alternate beneficiaries or a trust that enables you, with the help of a trustee, to control the money according to the instructions you provide for the trust.
Another situation in which you may not list an adult child as a beneficiary is if he/she does not need the assets. Because retirement plans/IRAs grow tax deferred, you may want to consider skipping a generation and listing grandchildren as beneficiaries. If anyone other than a spouse inherits an IRA, he/she typically establishes a beneficiary IRA and has to take out required minimum distributions (RMDs) each year based on his/her life expectancy. The two factors that determine the amount of the RMD are your life expectancy and the value of the account on December 31 of the preceding year. The larger the value and the shorter your life expectancy, the larger the RMD. So, by listing younger beneficiaries, you can “stretch” the IRA distributions over a longer period of time and allow for greater tax deferred growth. Sometimes this is called a stretch IRA.
Another way in which you might utilize a stretch IRA is if you don’t need any income from your IRA during your retirement. At age 70.5, you are required to start taking RMDs from your IRA. If you don’t need the income from your IRA but still want to leave your adult children an inheritance, you can still stretch your IRA with life insurance. Although I have never utilized this technique, you can use your RMDs to buy life insurance, list your adult children as the beneficiaries of the life insurance policy, and list grandchildren as the beneficiaries of IRA. By doing this, you provide your adult children with an inheritance while also stretching your IRA over longer life expectancies.
Again, you would want to discuss this plan with an experienced tax planner and estate planning attorney as generation skipping transfer tax could come into play.
Q: Do I have any control on how the beneficiary spends the money?
Mr. Edwards: You can control how the beneficiary spends money by listing a trust as the beneficiary of the retirement plan or IRA. Within the trust documents, you can establish for what expenses the trustee is allowed to withdraw assets from the trust for the benefit of the beneficiary. You can give the trustee as much latitude as you deem necessary. A common trust arrangement for a beneficiary is to allow withdrawals from the trust for health, education, maintenance, and support until he/she reaches a certain age. At that age, the beneficiary will receive the balance of the assets in the trust. This arrangement protects the beneficiary by allowing the trustee to meet specific financial needs until the assets are turned over at the listed age.
Choosing a beneficiary for your retirement plan is an important decision. Make sure you consider the options carefully and seek out appropriate professional advice.
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