It is often difficult to figure out how to complete your retirement account beneficiary designation. Do you have a living trust? Should you name your trust as beneficiary? Are you married? Do you intend to leave money to charities — and should that money come from your retirement account(s)? All of these questions make it difficult to come up with a clear answer applicable even in many (much less most) cases.
Naming your spouse
One generalization that works pretty often (but not always!) is that naming a spouse usually makes sense. Depending on the nature of your account, the applicability of federal law and state rules, that might have happened automatically. In fact, you may not have many choices (if you are married).
But that’s generally OK. We’re in no position to judge the strength of your marriage, but from a tax perspective spouses usually make the best beneficiaries. That’s because they can “roll over” your retirement account — delaying withdrawals and naming their own beneficiaries. That usually yields the best income tax result, and it’s the approach most commonly taken.
There are some narrow circumstances where you might not want to name your spouse. Rather than try to generalize about those unusual situations, we’ll just say this: talk to us (or your own estate planning professional) if you think that might be a better alternative. We’ll review the choices, the tax effect and how to accomplish what you want to do. Know that your spouse might very well have to consent to any change you make.
Charities as retirement account beneficiaries
Do you have charitable intentions? That is, are you planning on leaving any significant amount of money to one or more charitable organizations? If so, your retirement account might make the best choice. Recognize, though, that it might mean you have to pay more attention to your retirement account beneficiary designations.
Here’s a simplified illustration about naming a charity as beneficiary of your retirement account. We’re going to introduce you to Charles, who (conveniently) has one child, on favorite charity, and two assets. Charles has $100,000 in a bank CD, and a $100,000 IRA. He wants to leave half of his estate each to his daughter Gayle, and to the Lions Clubs International Foundation (his favorite charity).
Charles can name Gayle as beneficiary on his IRA and make his CD payable on death (POD) to the Lions Club. Or he can make each of them beneficiary as to 1/2 of each account. Or he can flip the script and leave his IRA to the Lions Club and his CD to Gayle. Which makes most sense?
If Charles leaves his IRA to Gayle, she doesn’t actually get $100,000. She’ll have to take the money out over the ten years after his death (thanks to the SECURE Act). She’s fairly wealthy, and she’ll pay about 35% in federal and state income taxes on her withdrawals. She can leave the money in the IRA for the ten-year period, letting it grow tax-deferred — but when she takes it out, she’ll pay that 35% in taxes. So she’ll get about $65,000 from the IRA. She’ll also get 65% of whatever the IRA earns before she withdraws it.
Meanwhile, if Charles leaves his CD to the Lions Club, they’ll get $100,000. They’ll get it immediately, too. So the net result: Charles’ choices mean his two intended beneficiaries will get a total of about $165,000, after taxes.
Flip the script: leave the IRA to the Lions Club
On the other hand, Charles could name the Lions Club as beneficiary of his IRA, and Gayle as the POD designee on his CD. When he dies, Gayle will get the $100,000 CD in cash (she can close it out immediately, by the way), and the Lions Club will get the $100,000 IRA.
The Lions Club will of course close out the IRA immediately, and they’ll have to pay the income taxes. But wait! They’re a charity, and their income tax rate is 0%! So they’ll get the entire $100,000. That means that Charles’ intended beneficiaries will get a total of $200,000 from his $200,000 estate, and no one will owe any income taxes. That’s a $35,000 improvement over the alternative approach.
Of course, Charles doesn’t exist. Nobody has one child, one charitable beneficiary, and two equal assets to divide. So let’s look at some of the complications by considering Meryl.
Meryl’s similar – but different – estate plan
Meryl has four children and one favorite charity (she likes Guide Dogs of America). Her entire estate is about $1 million; $250,000 of that is in a rollover IRA. The IRA is partly from her work and partly from her late husband’s estate. Meryl is 65, and she wants to leave 20% of her estate to Guide Dogs and to each of her children.
Obviously, her IRA is just a little too large to leave entirely to her charitable choice. In fact, it’s worse than that: over the next 7 years, she probably won’t take anything out of her IRA. If we assume that it will grow at, say, 3-4% per year, that means by the time she reaches age 72 it should be about $300,000. Meanwhile, her other assets might go down a little bit, since she is living on her Social Security and the occasional cash infusion from her accounts.
After Meryl turns 72, she’ll have to begin taking money out of her IRA. For the first few years it will probably grow faster than her withdrawals. By the time she turns 80 (or so) she’ll be taking out more than it earns each year.
It’s hard to predict how much Meryl will be worth on the day she dies. It’s even harder to predict how much of that will be in her IRA and how much in her other assets. So there’s a real challenge to figuring out how best to arrange her beneficiary designations.
Sorting out Meryl’s real intentions
If Meryl can decide today to leave $200,000 (based on her current net worth) to the Guide Dogs charity, we could name them as beneficiary for the first $200,000 of her IRA. Then we could transfer all of her other assets to a trust, which would provide that any amount necessary to get the Guide Dogs up to a total of $200,000 would come from her trust, with the rest to go to her children.
That can be problematic for a number of reasons:
- Meryl’s IRA custodian might not let her leave a flat dollar amount to one entity and the residue to be divided equally among her children.
- Meryl will probably worry about what happens if her estate shrinks before her death, and the Guide Dogs charity gets more than she intended.
What can she do about these problems? Well, she can just give up on income tax efficiency, and name the five beneficiaries to share equally on each asset. Or she can undertake to review her financial situation, her children’s needs and her attachment to the Guide Dogs charity on a regular basis — perhaps once every two or three years.
As we hope you can see, retirement account beneficiary designations can be challenging, and the best answer often changes with time. That’s why it’s so hard to get a straight answer from estate planning attorneys, CPAs or financial advisers about the best way to designate beneficiaries.
By the way, you might enjoy this week’s podcast episode, where we deal with some of these issues in the context of funding your revocable living trust. We call it Trust Funding 101, and it’s available wherever you get your podcast feeds. Our weekly podcast is called Elder Law Issues, and we’ve been helping people understand complex legal issues for almost two years in that medium.
But wait — there’s more!
Of course there is. But we’re going to stop here for now. In another installment, we will talk about beneficiary designations naming a child with a disability, or a chronically ill beneficiary, or your minor child. And the big question: when should you name your living trust as beneficiary of your IRA, 401(k) or other retirement account? That’ll be another long one.