Things You Should Know About IRA Beneficiaries: Part 2

In my last article, I discussed IRA beneficiary designations and how they specify who should receive your retirement account funds if you are to pass away. Besides understanding the different types of beneficiaries, it’s also important for readers to know how IRAs work (or don’t work) with wills and trusts, and to know what their specific beneficiary agreement means. In this article, we’ll take a look at both issues. (For more, see: What You Should Know About IRA Beneficiaries: Part 1.)

Wills and Trusts Don't Cover IRAs and Other Retirement Accounts

Basic estate planning involves setting up a will and trust. They are not the same thing and usually work in conjunction with each other. While IRA beneficiary designations are usually pretty low on the priority list, estate planning is even lower. It is one of those things that we know we need to do but for a variety of reasons, we don't.

There's a misconception that estate planning is just for the rich. It isn't. In addition, the estate planning process forces us to make decisions pertaining to our incapacity or death and many people just shut down during these conversations. It's an understandable reaction, but these basic documents need to be in place before something happens, not after. The old quote from Benjamin Franklin comes to mind: "An ounce of prevention is worth a pound of cure." This process isn't cheap either so that's another barrier.

For those that have set up their basic estate planning, kudos to you. You invested time and money and dealt with a difficult subject. Now after all of this, you find out that your will and trust, doesn't include your IRA beneficiary designations. That's right. This all-encompassing process of estate planning doesn't cover your retirement accounts. When I say this to clients, they look as if they're in shock. But, it's not as bad as it sounds.

It just means you can't neglect your IRA and other retirement account beneficiary designations and assume your will and trust override them. They don't. If you have an IRA with outdated beneficiaries and your will and trust says something different, the funds go to what is on file at the financial institution. If you've updated your will and your trust, you need to go back and update your IRA and other retirement accounts too. (For more, see: An Estate Planning Must: Update Your Beneficiaries.)

Understanding IRA Beneficiary Designation Agreements

There isn't a uniform standard that governs how financial institutions handle IRA beneficiary designations. When you designate beneficiaries, you are agreeing to that financial institution's terms. Be sure to read this agreement. Here's something to look out for.

I recently reviewed a large financial institution's terms regarding beneficiary designations. It states: "I understand that if a Primary Beneficiary predeceases me, the remaining portion will be divided proportionately among any surviving Primary Beneficiaries in the manner provided in the Individual Retirement Plan."

What does this mean? Consider the following scenario. You designate two beneficiaries and both are to share 50/50. One of those beneficiaries passes away leaving behind two children. You don't update your beneficiary forms with the institution. Later, you pass away. All of your account balance will go to the remaining living beneficiary. That means the heirs of the deceased beneficiary would be left out.

This may not be what the IRA owner intended when the designations were originally made. There are ways to protect against this but how it is done will likely vary depending on which financial institution you're working with. Some institutions will allow you to make per stirpes designations. This is a Latin legal term to describe the method of dividing a decedent's estate by family group. In the case of IRA beneficiaries, it is a way to make sure the heirs of a beneficiary aren't left out.

In the example below, the same scenario applies, but with the added per stirpes designation. This allows the heirs (child A and child B) to share in what would have gone to the deceased beneficiary. This designation makes a huge difference in how and to whom the funds are distributed.

IRA beneficiary designations are of major importance and should not be neglected. As our lives change, we need to be diligent in making sure our records are up to date and reflect our current goals and objectives. Failing to do so may result in major problems that could negatively impact relationships with family members. While the subject matter may be difficult to discuss, IRA beneficiary designations should be moved to the top of your financial planning to-do list. (For more, see: 5 Misconceptions That Put Your Finances at Risk.)