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Retirement Perspectives

Naming beneficiaries on each retirement account can help ensure that the intended heirs receive the proceeds in a timely and tax-efficient manner.

An often overlooked retirement-planning topic is beneficiary planning. I believe it can’t be stressed enough: Completing beneficiary paperwork for each and every retirement account owned is one of the most important administrative steps an accountholder can take. Ignoring or overlooking this seemingly easy step can lead to the wrong individual(s) inheriting your retirement nest egg.

But having named a designated a beneficiary is only the first step. Once completed, a beneficiary review should take place annually at a minimum to determine if updates are needed. Why is it so important to name beneficiaries on each retirement account? Because retirement accounts (individual retirement accounts (IRAs), 401(k)s, 403(b)s, 457, Thrift Savings Plan (TSP, retirement plan for federal employees), etc.) are not subject to probate; therefore, assets are not dispersed in accordance with the terms of a will.

 

Notify your financial team (advisor, attorney, CPA, and executor) of any and all beneficiary changes, including location of all your beneficiary forms, so they are easily located when needed.

 

When an IRA or 401(k) owner dies, there is no probate or other process necessary to transfer the funds to the beneficiary named on the beneficiary designation form. Instead, the account becomes the beneficiary’s property immediately upon the owner's death. So the named beneficiary will inherit the account. Therefore, not naming a beneficiary or having an incomplete form (e.g. not signed and/or not dated) can result in the account owner’s retirement assets being passed to unintended recipients. Or, the proper heirs may eventually receive the proceeds, but not necessarily in the most tax-efficient manner.

What is the simplest mistake that can cause major harm to an intended estate plan—and to your loved ones you wish to provide for through that plan?  It is having outdated (or missing) beneficiary designation paperwork for your IRAs, employer-provided retirement savings plans, life insurance policies, and other financial accounts. I believe now is the opportune time to commence a thorough review. For starters, check to see if you have a completed (e.g. signed and dated), current beneficiary designation form for all of your retirement account including those accounts that were established with a former employer. As you commence your review, you may be surprised to find how many designations have been neglected, misplaced, or even lost. The cost of neglecting naming a beneficiary can be significant!

Here are six common beneficiary errors that I see frequently:

Not naming a beneficiary—Account owners mistakenly think (or told) they can use their will to designate a beneficiary, as they do with other assets of the estate. But in the case of retirement funds, not naming a beneficiary leaves the beneficiary determination to the default terms of the IRA custodial agreement or plan document.  The agreement/plan document might name the estate or distribute the funds according to a succession order, such as spouse, children, grandchildren, etc. This may not be what the benefactor had in mind.

Naming your estate—Naming an estate as the beneficiary generally is not prudent. Although your heirs eventually will receive their inheritance, it will not be in the most tax efficient manner.

For example, the possibility of the "stretch" payout is forfeited. Why? Only an individual (spouse, kids, grandkids, friends, etc.) named as a beneficiary can receive distributions from an IRA, stretching over his or her full lifetime. This option is forfeited when an estate is the named beneficiary. Here, if the IRA owner dies before reaching their beginning date (RBD) for taking required minimum distributions (RMDs) (April 1 of the year after reaching age 70½), then the IRA must be distributed in full five years post death (“five-year payout”). If the owner dies on or after their RBD, then the IRA must be distributed over what would have been the account owner’s remaining life expectancy.

Failing to name a contingent beneficiary—If the primary beneficiary predeceases the account owner, who then fails to name a new primary beneficiary, the ultimate beneficiary is determined by the terms of the IRA custodial agreement or plan document.  The agreement/document likely will name the estate or distribute the funds according to a succession order (i.e., spouse, children, grandchildren, etc.).

Naming a charity as a co-beneficiary—When a charity is named as co-beneficiary along with an individual, the individual’s ability to “stretch” payments over the individual heir’s life expectancy can be lost without proper planning. The custodian has until September 30 of the year following the account owner’s death to pay out the charity’s full interest. The remainder of the account then can be distributed over the life expectancy of the individual beneficiaries. Failure to distribute funds to the charity in a timely manner most likely will subject the living beneficiary to take the entire payout over five years following the death of the account.

 

It is especially important to understand the distinction since most custodians indicate per capita as the default designation and not all custodians allow per-stirpes beneficiary designations.

 

Per capita versus per stirpes—Understanding this distinction is important in the event that a named beneficiary predeceases the account owner. If the beneficiary designations stipulate per capita—as most do—the assets, including the deceased beneficiary’s share, will be divided among the surviving named beneficiaries. However, per stirpes designation means that the inheritance of the deceased beneficiary will pass to his or her direct heirs.

Naming a Trust—Although naming a trust as an IRA beneficiary is a viable strategy, the rules are complex and trusts are expensive to draft and maintain. For more information about naming trusts as beneficiaries, read my earlier column: Naming a Trust as a Beneficiary of Retirement Accounts.

 

If your situation changes in the future, you can update/change your beneficiary at any time.

 

Life Events—Maybe you have recently married, divorced or remarried, welcomed the birth of a child, adoption, or the situations and financial needs of family members have changed. Also, moving from a non-community property state to a community property state or vice versa can impact your estate plan. Therefore, your “old” beneficiary designations likely will not produce results you desire now. Your will cannot fix this, because retirement account beneficiary designations prevail over the terms of a will. Instead, beneficiary designations should be complimentary to bequests by your will in an overall estate plan.

The same principles apply to beneficiary forms for employer-provided retirement plans (401(k), 403(b), 457(b), TSP, etc.), and Health Savings Accounts (HSAs), and other financial accounts. Obsolete and missing beneficiary forms can cause financial distress to your heirs.

 

GLOSSARY

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A required minimum distribution (RMD) is the minimum amount an account owner must withdraw from a retirement account each year. An owner generally has to start taking withdrawals from a retirement plan account at age 70½. Roth IRAs do not require withdrawals until after the death of the owner.

A Health Savings Account (HSA) is a savings account that lets employees set aside money on a pretax basis to pay for qualified medical expenses.

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

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