Thoughts On . . . Errors People Make with IRAs

As many of you are aware (particularly those who met me on a cruise ship), I regularly conduct seminars on estate and financial planning. One of my most popular is entitled "Deadly Estate Planning Errors . . . and How to Avoid Them."  Unfortunately, the errors people make with IRAs are so numerous and frequent that a separate discussion on how to handle IRAs is warranted.  Please consider this Thoughts On . . . piece to be that separate discussion.

A lot of people think that "estate planning" only means having a will. Not only is this view terribly short sighted in today's complex legal and financial world, it often overlooks important legal considerations in financial contracts that impact estate planning. For example, in a financial account which required the account owner to name a beneficiary when opening the account (whether a life insurance policy, annuity, 401(k), pension/profit sharing plan), that beneficiary designation trumps whatever that person's will recites. In other words, whoever is named as beneficiary in the account paperwork will receive the account proceeds when the account owner dies REGARDLESS of the will might indicate. The number of "inappropriate" beneficiary designations I see in my practice is alarming. The level of "inappropriateness" runs from . . . never designating a beneficiary . . . to naming beneficiary who is now dead . . . to naming an ex-wife (or husband) as beneficiary . . . to naming a business partner from a defunct organization . . . the list seems to be almost never ending.  So, everyone should check to make sure that beneficiary designations are up-to-date and adequately reflecting CURRENT estate planning goals and intentions. If someone is unsure of the beneficiary designation on an account, the company should be immediately called and a request made to review the account paperwork. It is also good practice to ask for a change of beneficiary form, so in the event a change in the beneficiary designation is warranted now, or in the future, the form to effectuate the change is in your posession.

Not only do accounts which require a beneficiary designation trump a will, they also avoid probate; that expensive, lengthy and cumbersome proceeding via which the title to property gets transferred from a decedent to a living person. Owning property in trust also avoids probate, but I am surprised at the number of people who do not realize that the proceeds from a life insurance policy, annuity, or tax-qualified retirement account (like an IRA) also passes to a beneficiary free of probate. Unfortunately, a HUGE error people make is either failing to name a beneficiary, OR naming someone who has died. In either of these cases, the proceeds of the IRA become payable to the account holder's estate. So? Well, that means the account proceeds become subject to probate! Of course, that is completely contrary to all competent estate planning, which seeks to minimize the exposure of one's estate to the probate process.

A companion error to failing to designate a living person as an IRA beneficiary and having the proceeds become payable to one's estate is the loss of potential IRA "stretch" benefits. Given certain family estate planning considerations, the Internal Revenue Code now allows certain IRA beneficiaries to withdraw the account value based upon the beneficiary's age (as opposed to the account owner's age), thereby "stretching" out the benefits over the lifetime of the beneficiary. For example, if a daughter is named the beneficiary of an IRA, and she is 50 when the account owner dies, she can stretch the required withdrawals over her 37 year life expectancy. If the IRA account is valued at $600,000 at the time of death, and it grows at 6% per year, she could receive a 37-year income stream totaling more than $1,000,000; and the account value at her death will still be greater than  $1,000,000. However, if the person's estate is the beneficiary of the IRA, this option is lost, as the heirs (either at law, or under the will) will be forced to withdraw the account value at the end of the fifth year after the year of the account owner's death; or if the account owner is over 70 ½ (and therefore taking required minimum distributions) within the time period which someone of that age is expected to live.

Along with a failure to designate a beneficiary, another error is not specifying how the account should be divided if multiple beneficiaries have been designated. For example, if five people are listed, but the intention is for one of them to get 50%, and the other four to divide the remaining 50%; the beneficiary designation MUST state that. If the beneficiary designation is silent, or unclear, the institution holding the account has to make a determination of intent and act accordingly. In the above example, the result would probably be 20% to each of the five beneficiaries. If a certain beneficiary feels aggrieved, then litigation over the estate is invited, which of course, is exactly what good estate planning seeks to avoid.

Another costly IRA planning error is lumping beneficiaries of significantly different ages into a single beneficiary designation. That is because in a multiple beneficiary designation, ALL of the beneficiaries are required to take minimum distributions based upon the expected lifespan of the oldest beneficiary. If one beneficiary is much younger than the other(s), then that younger beneficiary will lose the ability to stretch out payments as outlined above. As an example, assume  a 35-year old son and a 70-year old husband are lumped together in the same beneficiary designation. The husband's life expectancy is just 13 years while the son's life expectancy is 42 years. If the son elects a stretch pay-out, he is limited to an income stream based upon his father's 13 year life expectancy, even though his life expectancy is far longer. Those additional 29 years of tax deferral and compound growth which the IRA could offer are lost to him. However, the solution is quite easy: When beneficiaries of significantly different ages are present in the estate planning, simply divide the IRA accounts into two (or more) accounts so the beneficiary(s) of each account are of approximately equal ages.

I write, "the solution is easy," but all too often I see errors made simply because people failed to act appropriately. It truly is only "easy" if one gets good, competent, advice . . . and then acts on it!!