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Trust Company Corner: Prevent Beneficiary Designation Mishaps

Making simple elections now can help your IRA assets land where you intend later.

Imagine a scenario in which your ex-spouse receives your $2 million IRA after you die, despite your having designated your children as beneficiaries under your will. This scenario is not only possible, it has happened. But it's also preventable, provided you establish and maintain current beneficiary designations on your retirement accounts.

Wills and revocable trusts are the cornerstone of estate planning, and you may spend considerable time and money crafting and maintaining these documents over a lifetime. For all the effort that goes into traditional estate planning documents, however, many people do not give enough thought to filling out beneficiary designation forms for retirement accounts like IRAs. Their completion is important because the distribution of these assets generally is not covered by a will or revocable trust. Given the estimated $24.9 trillion in retirement assets in the U.S., planning for these assets has developed into a vital component of the estate planning process. 1

Why Beneficiary Designations Matter

When you purchase a life insurance policy, you designate beneficiaries in the policy documents. The same is true of retirement accounts, like IRAs and defined benefit or contribution plans. Designating beneficiaries on IRA documents means that your will or revocable trust does not control who inherits the property-these designations supersede the instructions in your will or revocable trust. So changes you make to your will to remove a spouse because of a divorce, for example, must also be made to your beneficiary designations. Although the laws of some states, such as New York, remove a divorced spouse as the beneficiary of a will, there often is no similar law covering IRAs, leading to the scenario in which ex-spouses may inherit IRA assets.

Not designating a beneficiary at all (or not updating the beneficiary designation forms after the death of a beneficiary) can cause further headaches. In that case, the administrator's plan documents may dictate who will inherit your IRA. Commonly, they send the IRA into your estate, where the beneficiary you want to receive the assets may not. Not having a designated beneficiary can also impact how quickly assets must be withdrawn from the account after your death.

Optimizing Beneficiary Designations

In addition to directing who will receive your IRA after your death, beneficiary designations determine the pace at which assets will need to be withdrawn. Due to their tax-advantaged status, it is generally preferable to keep assets in IRAs for as long as possible to allow the assets to grow on an income tax deferred basis.

Spouse designated beneficiary: Several options are available to a surviving spouse that is the designated beneficiary of an IRA. The most common option is to roll the inherited IRA into the spouse's own IRA. At this point, the assets are treated as if the surviving spouse is the original owner, and required minimum distributions (RMDs) begin at age 70 ½.

Non-spouse designated beneficiary: In general, non-spouse designated beneficiaries must begin taking RMDs soon after the death of the original IRA owner, but the amount of the RMD is calculated based on the beneficiary's age. Younger beneficiaries, therefore, can stretch out the IRA's tax benefits over a longer period than older beneficiaries, and potentially benefit from an extended period of tax-deferred growth. Naming a young beneficiary can make an inherited IRA an attractive wealth creation tool if your estate will not be subject to estate or generation-skipping taxes, or if that tax burden can be paid with assets outside the IRA (see below, Consider Estate and Generation-Skipping Taxes).

No designated beneficiary: When there is no beneficiary designation on file, the plan documents signed when the account is opened name the beneficiary. Frequently they provide that the IRA passes to the estate. If that happens, there is no option to stretch out the IRA distributions over the beneficiary's life expectancy. Instead, depending on when the original account owner dies, RMDs will be based on the original owner's life expectancy or the assets will need to be withdrawn in their entirety within five years of the owner's death. Either way, a potentially powerful wealth creation strategy is forfeited.

Using a Trust as a Designated Beneficiary

Many people incorporate trusts in their estate plans because they have minor children or beneficiaries that may not be able to manage an inheritance on their own. If you designate these individuals as IRA beneficiaries, they will have the ability to deplete the account as soon as they inherit it. A better option may be to name a trust as the designated beneficiary. If you create a trust under your estate planning documents, the same trust could be named as a designated beneficiary for your IRA.

Provided certain conditions are met, when a trust is a designated beneficiary, RMDs are calculated based on the age of the oldest trust beneficiary. Distributions from the trust are made according to the trust terms. The trustee, rather than the beneficiaries, has access to and control over the IRA and can decide to take minimum distributions over time or withdraw all of the assets and hold them in the trust.

Consider Estate and Generation-Skipping Taxes

IRAs and other retirement plans are subject to estate and generation-skipping taxes. If your estate's total value exceeds the current federal gift and estate tax exemption (which, in 2016, is substantial at $5.45 million for an individual and $10.9 million for a married couple), the IRA will be subject to federal estate taxes, as well as any applicable state estate taxes. If your designated beneficiary is a grandchild or a more remote descendant, the IRA may also be subject to generation-skipping taxes. Importantly, if IRA assets are withdrawn to pay those taxes, the withdrawal may also be subject to income taxes. While there is an income tax deduction available for the estate tax paid on IRA assets, all in, income and estate taxes may result in the depletion of much of the IRA's value.

This potential tax burden drives many wealthier IRA owners with charitable intent to consider designating a charity as a beneficiary. This approach tends to be a tax-efficient use of retirement assets, as it bypasses income, estate and generation-skipping taxes. In this case, it is common to name a charity as a contingent beneficiary, with the spouse (who is not subject to estate tax if a U.S. citizen) as the primary beneficiary. Then the surviving spouse has the option to disclaim the IRA if the funds are not needed, thereby passing it to the charity, or to roll it over into his or her own IRA where the charity can be named as beneficiary.

Seek Advice to Avoid Missteps

As retirement plans account for an ever-larger share of wealth, it is increasingly important to incorporate them into the estate planning process. The rules regarding beneficiary designations are complex and mistakes can be costly. Consider working with your financial advisor or estate planning attorney to help ensure your beneficiary designations are up to date and work well within the context of your overall estate plan.

1 Source: Investment Company Institute, as of March 31, 2015.

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice.

Tax planning and trust and estate administration services are offered by Neuberger Berman Trust Company. "Neuberger Berman Trust Company" is a trade name used by Neuberger Berman Trust Company N.A. and Neuberger Berman Trust Company of Delaware N.A., which are affiliates of Neuberger Berman Group LLC.

Neuberger Berman Investment Advisers LLC is a registered investment adviser. The "Neuberger Berman" name and logo are registered service marks of Neuberger Berman Group LLC.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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