IRA beneficiary designations specify who should receive your retirement account funds if you pass away. But there's much more to it than that. Despite the importance of naming beneficiaries, this is often at the bottom of the to-do list.
When an individual retirement account (IRA) is opened, it is often the result of a rollover from a company retirement account like a 401(k). A rollover is a very common transaction where you transfer funds from a 401(k) or other qualified retirement plan to an IRA. This process can be done without resulting in taxes or penalties that would otherwise be levied on a retirement account distribution.
A rollover transaction is just one of many events happening at that point in time. You've left one job and moved on to another. Maybe you are still in the process of finding a new job. Either way, life gets busy and oftentimes IRA beneficiary designations are either neglected or done in haste. What doesn't help matters is that discussions about death or considering our mortality can be difficult for some. (For related reading, see: An Estate Planning Must: Update Your Beneficiaries.)
Whatever the reason, it is important to give serious consideration to your IRA beneficiary designations. This article, the first of two about IRA beneficiaries, will cover some of the basic considerations and provide a solid foundation for making prudent decisions with regard to your IRA.
Primary vs. Contingent Beneficiaries
When you fill out an IRA beneficiary designation form, there are typically several spots to write in the person's information. It's important to pay attention to whether you're entering primary beneficiary information or contingent. A primary beneficiary is who you want the funds to go to first. Think of the primary beneficiary as being the first in line. The only way the primary beneficiary loses their spot in line is if they pass away.
Consider the following situation. You're single and you designate your adult sibling as your 100% beneficiary. Your sibling passes away before you, but you don't update your paperwork and you pass away soon after. Or, you are married and designate your spouse as 100% primary beneficiary and you both pass away in a car accident at the same time.
In these scenarios, your IRA will then become part of your estate and will be subject to the probate process. Probate is a public process through the court system. A judge will determine who should inherit the proceeds from your IRA. Probate is costly and time-consuming. Going through it defeats the purpose of designating beneficiaries in the first place.
This is where the contingent designation comes in. The contingent is second in line after the primary. If the primary beneficiary passes away before the account owner, the contingent beneficiary becomes the primary. Consider this as an added layer of protection to avoid the probate process.
Adding Multiple Beneficiaries
What is surprising about IRAs is that they don't require a beneficiary designation at all. This may vary between financial institutions, but for the most part, it is the IRA owner that decides whether to make designations. As a result, many IRAs are established with no beneficiary designation or left with outdated beneficiaries.
Many financial institutions will allow you to make multiple IRA beneficiary designations. For example, let's assume you're single and have four adult siblings. You want to make sure your siblings receive your funds if you were to pass away. You will likely be able to designate all four as primary beneficiaries and even allocate differing percentages to each. (For related reading, see: Distribution Rules for Inherited Retirement Plan Assets.)
If you're married, adding multiple primary beneficiaries might be problematic. The reason is that some states require a spouse to be 100% primary (sole beneficiary). If the IRA owner is married and specifies someone other than the spouse, the financial institution will likely require that the spouse sign off and provide their approval.
Naming Minors as Beneficiaries
Naming minors as beneficiaries is problematic. A minor is not able to make investment and financial decisions on their own. Courts will often require that a custodian be named to administer the IRA assets on behalf of the minor until they reach age 18. If you haven't provided specific instructions via some basic estate planning designating a legal guardian for the minor beneficiary, the courts will pick one for you. And you might not like their choice. If you have young children or are considering adding minors as beneficiaries, proceed with caution. Discuss these issues with an estate planning attorney with experience in this area to decide what the best way to accomplish this goal is.
In my next article, we’ll continue the discussion of IRA beneficiaries by looking at how they work (or don’t work) with your wills and trusts, and what specific beneficiary agreements mean.