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Beneficiary Designations for Traditional IRAs and Retirement Plans, Part 2

Beneficiary Designations for Traditional IRAs and Retirement Plans

(Part 2)

Other considerations when choosing beneficiaries

Income and estate taxes are very important considerations when choosing IRA and plan beneficiaries, but they are not the only factors that should enter into your decision. Never forget that, ultimately, you are deciding who will receive your IRA or retirement plan benefits after you die. Think carefully about who you want to provide for, and about how this decision fits into your overall estate plan. Consider the value of your IRA or retirement plan in relation to the value of all of your other assets. Designating the beneficiary of a $20,000 IRA that makes up five percent of your total assets is very different from designating the beneficiary of an

$800,000 retirement plan that makes up 80 percent of your total assets. In the first situation, your decision impacts only a small portion of your total estate. In the second situation, your retirement plan is the bulk of your estate.

Designated beneficiaries vs. named beneficiaries

Designated beneficiaries get preferential income tax treatment after your death. Being a "designated" beneficiary is not necessarily the same as being named as a beneficiary on a beneficiary designation form. IRAs and retirement plan accounts may have beneficiaries, but no designated beneficiaries. Designated beneficiaries are individuals (human beings) who are named as beneficiaries, do not share the IRA or plan account with nonindividuals, and are named in a timely manner. Charities and/or your estate can be named as beneficiaries, but they are not designated beneficiaries. A trust named as a beneficiary is not a designated beneficiary either, although the underlying beneficiaries of the trust can be designated beneficiaries under certain conditions.

The distinction between a designated beneficiary and a named beneficiary is important because designated beneficiaries generally have more flexible post-death distribution options, often resulting in more favorable income tax treatment. For example, only a designated beneficiary can use the life expectancy payout method for post-death distributions.

What happens if you have named both an individual and a non-individual (for example, a charity) as beneficiaries of your IRA or plan? Is the individual beneficiary allowed to use the life expectancy method to distribute his or her share? The answer is maybe. It depends on whether certain rules are followed. If you have left your IRA or plan to the beneficiaries in fractional amounts (as opposed to dollar amounts), the account may be divided into separate accounts up until December 31 of the calendar year following the year of your death. Then, the individual beneficiary can use his or her own life expectancy for his or her separate account. Or, the benefits due to the non-individual beneficiary can simply be paid out before September 30 of the calendar year following the year of your death. If the non-individual beneficiary has been fully paid off by the date indicated above, it is no longer considered a beneficiary for distribution purposes. (This approach can be used whether the non-individual beneficiary's share is expressed as a fractional amount or a dollar amount, but the separate accounts rules generally won't apply to pecuniary (specific dollar amount) bequests.)

If separate accounts are not established by December 31 of the year following the year of your death, or benefits are not paid to the non-individual before September 30 of the year following the year of your death, then your entire account will generally be treated as if there were no designated beneficiary.

The rules regarding separate accounts are complex. Consult a tax professional.

Primary and secondary beneficiaries

When it comes to beneficiary designation forms, your goal should be to avoid gaps. If you do not have a named beneficiary who survives you, your estate may end up as the "default" beneficiary of your IRA or plan. That typically produces the worst possible result in terms of estate and income taxes and other issues.

Your primary beneficiary is your first choice to receive your retirement assets after you die. You can divided equally among multiple beneficiaries. For example, you can leave 60 percent to one of your primary beneficiaries, and 20 percent each to your other two primary beneficiaries.

In addition, you can designate multiple beneficiaries by name or by a grouping. For example, you might want to name your spouse as your primary beneficiary and your children as the secondary beneficiaries. You can do this by providing the full name of each person, or by listing them simply as "my spouse who survives me" and "my children who survive me."

In some cases, you may want to designate a different beneficiary for each of your retirement accounts (assuming you have more than one), or divide an account into separate subaccounts (with a separate beneficiary for each subaccount). This could potentially allow each beneficiary to use his or her own life expectancy to calculate required post-death distributions, providing greater income tax deferral for your beneficiaries in many cases. If you do this, however, you should try to plan withdrawals from the different accounts accordingly. Taking most of your distributions from one IRA or plan account could leave the beneficiary of that account with less money than you had intended.

If you have more than one beneficiary you want to provide for, the advantage of having one retirement account (or as few as possible) with multiple primary beneficiaries is reduced paperwork and record keeping. Account consolidation may also save you money in annual fees and other expenses. The drawback is that this may limit post-death options. For example, say your children are all named as primary beneficiaries of your one IRA, and they want to use the life expectancy method for post-death distributions. The calculation would generally have to be based on the age of the oldest child, subjecting the other children to a shorter payout period than they could otherwise have.

This outcome can be avoided, however, if separate accounts are established for the children at some point. An IRA or plan account with multiple designated beneficiaries can generally be split into separate accounts at any time up until December 31 of the year following the year of your death (but note that designated beneficiaries are determined by September 30). Each account and its beneficiary might then be treated separately for purposes of determining required post-death distributions.

The rules regarding "separate accounts" are complicated. Consult a tax professional.

When do you have to choose your beneficiaries?

In the past, you typically had to choose a beneficiary for your IRA or retirement plan by your required beginning date for lifetime RMDs. Your choice was then "locked in" (at least for certain purposes) on the earlier of that date or the date of your death. The final IRS regulations issued in 2002 extend the deadline for finalizing your beneficiary choices for purposes of post-death distributions until September 30 of the year following your death. This gives you greater flexibility because you are now free to change beneficiaries any time during your life. Changes made after your required beginning date usually will not affect the distributions you are taking (since your choice of beneficiary, unless it is a more than 10 years younger spouse, now has no bearing on the calculation of your RMDs during your lifetime).

The final regulation distribution rules also create significant opportunities for post-death planning. Since your IRA or plan beneficiaries are not finalized until September 30 of the year following your death, a beneficiary could either disclaim (refuse to accept) or cash out (withdraw) his or her share of the inherited funds by this deadline. That beneficiary would then be removed from the list of designated beneficiaries. Only those beneficiaries remaining as of the September 30 deadline would be considered when determining required post-death distributions from the account.

Although the date for finalizing beneficiaries for distribution purposes is September 30 of the year following your death, an IRA or plan account can be split into separate accounts up until December 31 of that same year. Again, consult a tax professional regarding the rules for separate accounts.

Paying death taxes on IRA and plan benefits

Consult your estate planner as to the source to pay any death taxes due on your IRA and retirement plan benefits. Depending on the death tax payment clause in your will and/or trust and state law, it could be that other assets are used to pay death taxes, or it might be that the benefits will be diminished by the payment of death taxes. An important part of completing your beneficiary designations is making sure that the source of payment of death taxes does not conflict with your overall estate plan.

Your options when choosing your beneficiaries

The terms of your IRA or retirement plan may govern your beneficiary designations. As discussed, many qualified retirement plans require you to designate your spouse as beneficiary or, alternatively, that you have your spouse sign a consent and waiver. Some name more than one person or entity as your primary beneficiary (see below--Having multiple beneficiaries). If your primary beneficiary does not survive you or decides to decline the inherited funds (the tax term for this is a "disclaimer"), then your secondary beneficiaries (also called "contingent" beneficiaries) receive the assets. Typically, the beneficiary designation form that you complete will have separate sections for the different levels of beneficiaries.

Having multiple beneficiaries

You may generally name more than one primary beneficiary to share in the IRA or retirement plan proceeds. You just need to specify (on the beneficiary designation form) the portion of the funds that you want each beneficiary to receive. This can be expressed as fractional amounts (i.e., percentages) or as fixed dollar amounts. Fractional or percentage amounts usually make more sense, since the dollar value of the account usually fluctuates with the underlying investments and the separate account rules (discussed below) generally won't apply to pecuniary (specific dollar amount) bequests. The account does not have to be

states (particularly community property states) may require similar spousal consent for IRAs.

Assuming you have a choice, you should carefully consider your options and seek qualified professional advice. The designation of a beneficiary can involve income taxes, estate tax, and other important non-tax issues. Often it will make sense to name your spouse as beneficiary of your IRA or retirement plan benefits. In other cases, it may make sense to name a child, grandchild, or other individual, a trust, a charity, or in rare cases, your estate, as beneficiary. Make sure you understand the advantages and disadvantages of each particular beneficiary choice.

Content provided by Broadridge Communications

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