This post is a follow up to our prior discussion of the importance of beneficiary designations https://oakfingroup.com/importance-designation-beneficiaries-retirement-accounts-part/. Let’s turn our attention to understanding how they work with retirement accounts.
There are two basic types of beneficiaries – primary and contingent. Primary beneficiaries are the account owner’s first choices to inherit the retirement assets. Contingent beneficiaries are those selected to inherit the assets in the event there are no surviving primary beneficiaries. The key is to make sure that you understand exactly what you have chosen to do and the impact of your choices.
Not surprisingly, most married individuals name their spouse as their designated primary beneficiary. But because the rules differ depending on whether the designated IRA beneficiary is or is not a spouse it is important to understand these distinctions.
Special rules allow for a surviving spouse to have the option of rolling the decedent’s IRA directly into their own IRA and treating the assets as if they were always part of their own IRA. If the surviving spouse does not have an existing IRA account at the time of their spouse’s death, they can convert the decedent’s IRA into their own.
Non-spouse beneficiaries, however, do not have this rollover option and cannot treat the decedent’s assets as their own IRA. Instead, non-spouse beneficiaries generally have three options:
- They can liquidate the IRA in a lump sum. The entire amount is subject to federal and state income tax.
- They can defer liquidation (or conduct periodic distributions) for a period of up to five years. No minimum withdrawals are required during the five-year period, but the account must be fully distributed by December 31 of the fifth anniversary year of the original account holder’s death. Distributions are subject to federal and state income tax.
- They can choose to take only the minimum required annual distributions (the required distribution amount is determined based on the beneficiary’s life expectancy, not decedent’s life expectancy) by December 31 of the year following the year in which the account owner died and continuing annually thereafter for the beneficiary’s lifetime. This option prolongs the tax deferred “life” of the IRA. Each distribution is subject to federal and state income tax.
It is important to periodically review beneficiary forms to be sure your intentions will be met and that changes are not needed. Consider the following four scenarios:
- If a sole, primary beneficiary is named and dies before (or with) the account owner, then any listed contingent beneficiary or beneficiaries will inherit the account in accordance with the account owner’s instructions.
- If a sole, primary beneficiary is named and dies before (or with) the account owner, (no new primary beneficiary was named as a replacement), and no contingent beneficiary was named, then there are no valid beneficiaries. The retirement account will be considered part of the account owner’s estate.
- If two primary beneficiaries are named and one of them predeceases the account owner, then typically the surviving beneficiary receives the entire 100% share of the account. For example, if an account owner has a brother and a sister and intends for each sibling to inherit a 50% share of the assets, then both siblings should be listed as 50% primary beneficiaries. In the event the sister was the first to die (before the account owner), the brother as the sole surviving primary beneficiary would inherit 100% of the account.
- Now suppose that the brother and sister in example number three each had children of their own and the intention of the account owner was not just to take care of his siblings, but also their children. The account owner must list his two siblings as per stirpes primary beneficiaries to protect the interests of his sister’s children. Without choosing a per stirpes designation, the sister’s two children would inherit nothing. By using a per stirpes designation, the brother receives his 50% share, and the deceased sister’s children automatically split her 50% share equally.
It is an account owner’s responsibility to understand the precise terms and language of their financial institution’s beneficiary designation form and carefully consider their options. In addition to the discussion above, it should be noted that there are special rules that apply when a trust or charity is named beneficiary. We recommend you speak with your financial advisor, accountant, and/or attorney to be sure your wishes will be met and that you understand any tax and inheritance implications.