In financial planning, sometimes the simplest and most mundane of tasks can have the biggest impact.

Few places is that more clear than in the process of inheriting and rolling over IRAs, said Sarah Brenner, director of retirement education for Ed Slott and Company, who feels that too many retirement savers and advisors are overlooking the beneficiary designation form.

“The beneficiary designation form is the Rodney Dangerfield of estate planning documents,” in that it gets no respect, said Brenner, who added that advisors should keep in mind that beneficiary forms trump all other estate planning documents. “A beneficiary form is like a piece of paper: It’s free to fill out and people don’t take it seriously. That’s a huge problem. The beneficiary form is what determines how the retirement assets will pass to the next generation.”

A Costly Mistake

Speaking at Ed Slott and Company’s two-day Instant IRA Success workshop in Las Vegas last month, Brenner discussed several horror stories that stemmed from incomplete, lost or poorly completed beneficiary forms.

A USA Today story last month, for example, told of a widow in Las Cruces, N.M., with multiple sclerosis who was left a $1 million pension by her husband. But she couldn’t find her beneficiary form. Since she couldn’t prove that she was intended as the account’s beneficiary, the pension agreed to pay out only what her husband paid into the system, and not the actual pension payments.

“Every client that has a major life event like a birth, death, marriage, divorce, remarriage—every time that the tax laws change, call them and say I want to do a beneficiary form checkup,” said Slott.

In Herring v. Campbell, a 2012 case before the 5th Circuit Court of Appeals, a client’s beloved stepchildren were disinherited because he had failed to update his beneficiary forms. The client had named his spouse as his beneficiary, but his spouse predeceased him by one year and he never updated his form.

When a retirement account beneficiary predeceases the account holder and the beneficiary form is not updated, the standard default rules for account inheritance apply. Courts will consider potential heirs starting with a surviving spouse, then children, then parents, then siblings and finally the estate of the deceased.

In Herring v. Campbell, the courts agreed with the benefit administrators that stepchildren are not considered children for the purposes of determining who will inherit the account’s assets. The administrators decided that the assets should be inherited by the client’s siblings.

The stepchildren in Herring v. Campbell eventually sued the plan and won, as the client had already left his entire estate to them.

Beware of Bad Advice

Jeremy Rodriguez, an IRA analyst with Ed Slott & Company, brought up another beneficiary planning case where a man, Elroy Earl Morris, inherited his father’s $95,900 IRA as the sole beneficiary of the account. Morris decided that his two siblings should also get a share of the account and approached a law firm about transferring some of the money to his brother and his sister, asking if there would be any tax implications.

“If you think something will be easy, don’t just delegate it down,” said Rodriguez. “This was delegated to a paralegal who said that there would be no tax consequences if he transferred money to his brother and sister. But the paralegal was thinking about estate taxes, and those didn’t apply in this case. That wasn’t the case with income taxes."

Morris took a full distribution from his father’s IRA to split the account’s assets between himself and his siblings, which resulted in the full amount being taxable to him. In 2015, a tax court upheld the income tax charge to Morris.

Rodriguez pointed out that the tax bill could have been avoided if the account’s beneficiary form had divided it among Morris and his siblings.

“He also could have considered a disclaimer as a solution,” said Rodriguez. “He could have disclaimed that (money). ... It would have went to the estate, and the brother and sister would have gotten a piece of the IRA without him being hit with income tax.”

Rodriguez cautioned advisors to be wary of legal advice that they receive, especially concerning IRA and tax treatment in the beneficiary process.

In another case discussed by Rodriguez, Mickey Liu, an HBO executive, named an Atlantic City, N.J.-based exotic dancer as the sole beneficiary of all of his accounts. After Liu passed away at a young age, his sister sued the exotic dancer over the assets in his accounts. The court ruled in favor of the dancer.

“In general, retirement accounts can’t be assigned or transferred after death. The only exception is a qualified plan in a divorce,” said Rodriguez. “ERISA has anti-assignment rules.”

When Rulings and Regulators Clash

In some cases, state courts rule one way while the IRS rules another. In the end, the IRS is not governed by state court decisions.

Rodriguez discussed an IRS private letter ruling where a late IRA owner had left his account to his daughter. However, the state was a “community property state,” where any amount that was earned or accrued during his marriage could be considered the property of his spouse.

“The spouse went to court against her son, and the state court ruled in her favor. The account had to be transferred,” said Rodriguez, adding that the court assigned a portion of the IRA to the spouse as a spousal rollover IRA. “She filed for a private letter ruling asking the IRS to bless this and the IRS said no because the beneficiary form did not list her. It listed a non-spouse, her son.”

The tax code states that IRA assets are not subject to community property rules. In its private letter ruling, the IRS also ruled that any assignment of assets to the spouse should be treated as a distribution taxable to the son. In the case in question, the son was responsible for an expensive tax bill that might have been avoided if the deceased client’s beneficiary forms were in order.

Rodriguez recommended that advisors and their clients should get the written consent of their spouse if they choose to name someone else as the beneficiary of their IRA in states where the community property rules are in place.

Slott recommends that advisors keep copies of beneficiary forms for every IRA and retirement account owned by their clients, making sure that a beneficiary is named in writing, and also check to see that a secondary or contingent beneficiary is named. If multiple beneficiaries are named, advisors should be sure that each name and share is clearly stated, and that the shares add up to 100 percent, or that fractional shares add up to one.

What Makes a Designated Beneficiary

Account holders might be confused by the difference between beneficiaries and designated beneficiaries. While a beneficiary can be any person or entity, a designated beneficiary must be a living, breathing person, said Andy Ives, another IRA Analyst with Slott & Co.

“As a general rule, never, ever name an estate as a retirement plan beneficiary,” said Ives. “When it comes down to it, the beneficiary choice has to do with the goals—the goals that the original IRA owner had and the goals of the beneficiary. Most of the time, account owners and beneficiaries want to transfer assets in the most efficient way, minimize costs and taxes, and stretch out the distributions for those assets.”

If an estate is named as a beneficiary, then the ability to stretch the IRA over the life expectancy of a designated beneficiary is lost.

Ives discussed a 2003 private letter ruling from the IRS that allowed an inherited IRA where the estate was the original beneficiary to be split up so that a non-spouse beneficiary could receive a one-third interest in the account. But doing so eliminated the non-spouse beneficiary’s ability to stretch RMDs over their lifetime.

“If an estate becomes the beneficiary, then the IRA becomes a probate asset,” said Ives. “It has to go to probate and there are estate fees and court costs incurred if you name the estate as the beneficiary.”

Naming a trust as a beneficiary does not always avoid the loss of the stretch strategy, said Ives. A 2012 private letter ruling from the IRS confirmed that, in a case where an IRA willed to a trust and then divided among the IRA owner’s four children, the trust was not technically a designated beneficiary. The IRS ruled that the ability to stretch the account was lost.

IRA Beneficiary Choices

Brenner explained that there are three different kinds of beneficiaries: charities, spouses and non-spouses.

“A charity is a great traditional IRA beneficiary, because most of the time distributions from a traditional IRA are going to be taxable. But a charity does not pay income taxes,” she said. “This is a good topic to discuss with clients. They want to think about revisiting charitable requests within their will.”

However, using a charity as a beneficiary may also eliminate the possibility of using the stretch IRA strategy, said Brenner. If an account owner wants to leave part of their IRA to charity, advisors may want to split the account up while they’re still alive so that any designated beneficiary could still use the stretch, he said.

An account owner could also name a charity as a secondary beneficiary to the account, said Brenner. That way, the primary beneficiary could disclaim any portion of the account they wish to go to the charity.

When a spouse is named as an IRA beneficiary, they have the opportunity to exercise a spousal rollover where they inherit the funds and roll them over into their own IRA. This is most often accomplished with what’s known as a “60-day” rollover, said Brenner.

“These funds are treated as if they were always in the living spouse’s IRA,” said Brenner. “If they’re under 70 and a half, they don’t have to take any distributions from their IRA, and that’s a good thing. The bad news is if they’re under 59 and a half and they do a spousal rollover, and if they take distributions, they’ll be hit with a 10 percent early distribution penalty.”

Once the surviving spouse elects to roll over the IRA assets, it’s an irrevocable decision. But there’s no deadline to take a spousal rollover. They could keep the account as an inherited IRA for as long as they like. Depending on the age difference between spouses, different IRS life expectancy tables may apply to determining minimum distributions from the account.

In the event that one spouse passes away at a young age, the surviving spouse may elect to keep the IRA in the deceased spouse’s name, which would allow them to delay taking required distributions until the deceased spouse would have been 70 and one half. This also works if there is a large age difference between spouses. 

Spousal beneficiaries also have the ability to recalculate their life expectancy on an annual basis, which may lead to a slightly smaller RMD over the long term, said Brenner.

Spousal beneficiaries, upon inheriting an IRA, should immediately name new beneficiaries to avoid having the account default to the estate upon their own death and going through the probate process. Doing so also preserves the stretch strategy for future beneficiaries.

Non-spouse Beneficiaries

Non-spouse beneficiaries can be children, grandchildren, siblings, parents, a trust, an estate or a charity, said Brenner. Only a living, breathing person named on a beneficiary form is eligible to use the stretch IRA strategy, with one exception—if a “see-through” trust is named as beneficiary.

Ed Slott & Co. recommends against using trusts as IRA beneficiaries as they often cause more complications and additional costs than they’re worth. The company lists 11 reasons that a trust might make an appropriate beneficiary:

  1. If the potential designated beneficiary is a minor, disabled, incompetent or unsophisticated
  2. To rpvoide an income stream
  3. To protect the family’s retirement assets in a second marriage situation
  4. To guarantee a lifetime payout to beneficiaries via a stretch IRA
  5. To avoid estate tax or inclusion in the beneficiary’s estate
  6. For generation skipping purposes
  7. To set up a continuation plan for distributions after the death of a beneficiary
  8. To control the disposition of large IRAs
  9. Creditor protection
  10. Divorce protection
  11. To fund charitable bequests via charitable remainder trusts

When a trust is named as an IRA beneficiary, the RMDs are calculated using the life expectancy of the eldest trust beneficiary.

To qualify as a see-through trust that can preserve the stretch IRA strategy, a trust must:

After an account owner dies, the IRA enters a “GAP period” stretching from the date of death to Sept. 30 of the year following the account owner’s death. The GAP period allows beneficiaries and advisors a period to plan the inheritance process by using disclaimers, distributions and account splitting.

If an inherited IRA is split among multiple designated beneficiaries during this GAP period, each beneficiary can still use the stretch IRA strategy using their own life expectancy. However, if the account is split after the GAP period, all beneficiaries may end up bound to use the shortest life expectancy among them to calculate their RMDs.

Ed Slott & Co. offers a short checklist of instructions after the death of an IRA owner:

  1. Touch nothing until a plan is in place.
  2. Make sure the inherited account is properly titled.
  3. Split the IRA if there are multiple beneficiaries.
  4. Calculate required distributions.
  5. Make sure new beneficiaries are named and beneficiary forms are filled out.
  6. Manage any IRA-related trusts
  7. Change investments on inherited IRAs
  8. Trustee-to-trustee transfer for non-spousal beneficiaries.