Read the Fine Print of Your Beneficiary Designation Form!

When an individual opens an individual retirement account (“IRA”), the beneficiary designation form must be completed.  If married, many individuals will name their spouse first and then their children, if any. While this designation may or may not be good planning, an issue can arise if these named beneficiaries are deceased or worse the beneficiary designation can not be found at the company. In this author’s experience, most clients do not read the IRA contract which may control what happens in such a case.

What happens if the spouse and a child have predeceased the owner of the IRA? How will that share be distributed? For example, Joyce and Bill are married with 3 adult children, Lily, who has 3 children, Tom and Cathy. Joyce dies with $1,200,000 in her IRA and Bill and Lily have predeceased her. How much does each beneficiary receive?  Is it divided only between Tom and Cathy such that each get $600,000 or do Lily’ 3 children (the account holder’s grandchildren) receive Lily’s share (a “per stirpes” distribution) such that Tom and Cathy each receive  $400,000 and $400,000 is divided between Lily’s 3 children? Is the beneficiary designation governed by survivorship or per stirpes? This plan of distribution is governed by the IRA contract unless the owner specifically states survivorship or per stirpes.

What happens if the beneficiary designation is lost by the company? The presumption is that there is no beneficiary designation, even though you actually filled it out! After the account owner’s death, the responsibility will be on the beneficiary to not only produce the beneficiary designation, but PROOF that it was actually delivered and received by the company. Of course the beneficiary can always sue the company for the lost beneficiary designation but the time and expense may be prohibitive.

If there is NO beneficiary designation, then generally the default beneficiary will be the estate which is the worse outcome if deferral of income tax is desired.  Immediate payment of income tax will be due upon distribution to the estate. Alternatively, if no beneficiary is named, then the default beneficiary may be provided n the IRA contract. For example the first beneficiary may be the spouse, then to children, then to lineal descendants, then to siblings, then to nieces or nephews. While this MAY work for some people, many people may not want their spouse to be a default  beneficiary (think second marriages with step-children).

What if one of the beneficiaries is disabled?  IRA distributions to such a beneficiary could easily disqualify the disabled beneficiary’s entitlement to Medicaid and other government benefits.

What if the children are minors? Ultimately, a minor guardianship may have to be established with more expense and complexity than would be necessary if there was a properly named beneficiary such as a “see through” trust.

ADVICE: Periodically examine your beneficiary designations on file with the company that holds your IRA. Further, make sure that you read the IRA contract and understand what happens if one of your beneficiaries predecease you. If you become incapacitated, then you may not have a chance to change the beneficiary designation once someone has predeceased you. If, however, you have a durable power of attorney, this is one of the powers you could give to your agent.

WORD OF THE WEEK: Inclusion Ratio (“IR”) is the ratio of a trust to determine how much of the trust is subject to generation skipping transfer tax (GSTT”). This tax has been discussed in a prior blog. The IR is 1 less the amount of the GSTT exemption allocated to a trust over the total amount of the assets (this fraction is called the “applicable fraction”). Thus, if you have a trust of 2 million dollars and 2 million of GSTT exemption is allocated to the trust, then the IR would be 1 less the applicable fraction of 2 million/2 million or 1 less 1 or ZERO. With an IR of ZERO there is no GSTT on any distribution from this trust. However, if only 1 million of GSTT exemption is allocated to the trust, then the IR would be 1 less the applicable fraction of 1 million/2 million or 1 less 1/2 equals 1/2 which means the IR for the trust is 1/2 and 1/2 of every distribution is subject to the GSTT. The goal is to always have a ZERO IR so no trust distributions are subject to GSTT.


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