The Importance of Conducting an Annual Beneficiary Audit

According to the Investment Company Institute, total US retirement assets exceed $23 Trillion, mostly in employer-sponsored retirement plans and IRAs. Baby Boomers have been planning and saving for retirement for decades. They are also planning their legacy; creating wills, trusts and other sophisticated estate planning strategies to transfer their wealth to the next generation. However, most people may not realize that their IRAs and qualified retirement plans, a large part of their estate, are not subject to probate nor affected by the terms of a person’s will. These assets will pass to the next generation determined solely by the client’s beneficiary designation form. Accordingly, the beneficiary designation form is one of your client’s most important estate planning documents but it is often overlooked when creating a legacy plan.

Here are some common beneficiary designation mistakes to avoid:

Estate as a Beneficiary

Many clients unintentionally name their estate as beneficiary of their retirement accounts. Some clients will actually direct their retirement assets to be paid “pursuant to the terms of my will”. Other clients simply fail to complete their beneficiary designation form or forget to name a new beneficiary after a beneficiary dies. When this happens, the assets are usually paid to the client’s estate by default, which is probably the worst beneficiary for IRAs and retirement plans.

IRAs and qualified retirement plans, assets that normally avoid probate, will become subject to probate when paid to the estate. The probate process can be long, cumbersome and expensive. Furthermore, these assets may have to be liquidated and paid to the estate within five years after the client’s death. While individual beneficiaries can elect to have IRA assets paid over their lifetime, thereby “stretching” their tax liability over many years, estates cannot.  Finally, estates are subject to a much higher income tax rate than individuals. This can result in more money going to the IRS than necessary. To avoid this mistake, simply make sure your clients have an up-to-date primary and contingent beneficiary designated for all their retirement accounts.

Trust as a Beneficiary

Many attorneys like to use trusts to facilitate an effective transfer of wealth and maximize all available gift, estate and generation skipping tax exemptions. However, there are several dangers to having retirement assets paid to a trust. First, the IRS generally requires the assets to be paid to the trust within 5 years after the death of the client. The “stretch” rules generally do not apply to trusts unless the trust is drafted to be a “look through” trust. If the trust is a “look through” trust, then the IRS permits you to “look through” the trust and “stretch” the IRA to the trust over the life expectancy of the oldest trust beneficiary. Trusts that fail to be a “look through” trust include those that have beneficiaries that are not individuals, such a charity, estate or another trust. Second, it can be expensive to establish and maintain these trusts. If an IRA is “stretched” to a “look through” trust, a lifetime of legal, trustee and administrative fees can significantly reduce the amount the ultimate beneficiaries will receive. Third, trusts become subject to the 39.6% tax rate (currently the highest) as soon as the income exceeds $12,400 (for 2016, indexed for inflation). By comparison, married taxpayers filing jointly do not reach the 39.6% tax rate until their income exceeds $466,950. That means if the IRA payable to the trust is worth more than $12,400, more than a third can be lost to the IRS. Unless there is a compelling non-tax reason to name a trust as beneficiary of an IRA or retirement plan, you should help your clients avoid making a costly mistake. Encourage your clients to speak with their estate planning attorney about the pros and cons to naming a trust as a beneficiary of a retirement account.

Ex-Spouse as a Beneficiary

Few people really intend to leave IRA and retirement assets to an ex-spouse. But this happens all the time. People fail to update their beneficiary designation form after a divorce. Many times they are under the mistaken belief that the divorce decree will automatically negate their prior beneficiary designations. It does not. Divorce decrees, court orders and wills generally have no affect on a beneficiary designation. 

All clients should conduct a beneficiary audit when there has been any major life event such as a birth or death in the family, a marriage and, most importantly, a divorce.

“Per Stirpes” or “Per Capita”

IRA and retirement assets are not always distributed as intended. Most IRAs will allow the owner to designate multiple beneficiaries. For instance, it is common for an IRA owner to designate his or her children as equal beneficiaries. If one beneficiary predeceases the owner or “disclaims” the inheritance, the remaining primary beneficiaries will generally receive the balance of the IRA and not the children of that deceased beneficiary.  This surprises many people. For instance, let’s assume Dad has an IRA he wants to leave to his two children Sue and Tom. Sue and Tom also have children of their own. If Tom were to die before Dad, Sue would inherit Tom’s share and nothing would go to Tom’s children. This is called a “Per Capita” distribution. If Dad wanted to make sure Tom’s share will benefit Tom’s family, Dad should make a “Per Stirpes” designation. This means Tom’s half will be shared equally by Tom’s children.

Conclusion

By conducting a review of your clients’ IRAs and retirement plans, you can help your clients avoid costly mistakes and assure the right beneficiaries inherit these hard-earned assets.

Note: This article was originally published in December 2016. It is possible that some information may have changed since publication. Please consult your financial, tax or legal advisor for current information

The Prudential Insurance Company of America Newark, NJ

This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.

Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Since individual needs and situations vary individuals should consult with their tax and legal advisors regarding their personal circumstances.

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