Your dad worked hard, saved and invested. Upon his death, he had amassed a significant sum in his IRA account. Your mom passed away last year, so you stand to inherit his substantial retirement savings, right?
Well maybe not. If mom was his named beneficiary and he never changed it, that tidy nest egg might end up going to the animal shelter and his other favorite charities instead of you. Surprise.
Christopher HopkinsUnintended outcomes like this are easily avoided but happen all the time. That is why it is so important to periodically verify the beneficiaries listed on your retirement accounts.
IRA accounts are unique in several respects, including their treatment upon the death of the owner. Unlike most other assets like real estate and bank accounts, IRA accounts and 401(k) plan assets do not pass to heirs through the normal probate process. That is, unless you goof.
Retirement accounts are designed to bypass probate and transfer directly to the intended recipients. If handled correctly, they retain their tax deferred status, allowing the inheritors to stretch the distribution over a considerable period of time and spread out the tax burden. Generally, a non-spousal beneficiary can choose to take regular distributions over her lifetime, or alternatively distribute the assets completely within five years rather than taking the hit all in one year.
But what happens if there is no designated beneficiary? What if the person originally named has died, or if no one was ever specified? Things get more complicated and the advantages of the IRA disappear.
Each IRA custodian (brokers, banks, insurance companies) specifies the default action if there is no living beneficiary. In some cases, a surviving spouse receives the assets just as if they had been named on the document as a beneficiary. But more often, the retirement account becomes part of the decedent’s estate, to be distributed according to the will along with all other assets.
The IRS does allow an executor to distribute IRA assets intact to heirs and preserve the tax deferral, but some custodians do not allow it. Even if the executor can transfer the account, the opportunity to stretch distributions over the remaining lifetime of the heirs is lost and the money must be withdrawn within five years unless the original owner was taking required distributions.
In many cases, the entire IRA account must be distributed immediately to the estate and the tax bill becomes payable this year. The assets merely become part of the larger estate just like the gun collection and the Hot Wheels set.
Sound confusing? It gets worse.
Suppose Dad remarried 10 years ago but forgot to change his beneficiary after the divorce. In states without community property laws, guess who receives a pleasant surprise in the mail down in Florida. Wife number one.
Meanwhile, one important attribute of retirement accounts is their shelter from creditors. Once the IRA assets pass into the estate, they become available to satisfy any outstanding debts of the decedent or the estate (after taxes, of course).
Don’t be that guy. Review the beneficiary designation on your IRA, 401(k), 503(b) and any other retirement accounts. This is especially critical if something major has changed, like a divorce or the death of a spouse.
Also be sure to name “secondary” or “contingent” beneficiaries. There will be spaces on the account form to name one or more people to stand next in line in case the primary beneficiary is no longer living.
Beneficiary designations can be changed at will as often as necessary, and the process is easy. Failing to do so could lead to a most unpleasant surprise.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.