IRA beneficiary designations are a confusing topic to many clients and even to some advisors, but mastering the details of IRA beneficiary rules can strengthen relationships with clients, reduce income taxes and estate taxes, and ensure that a family’s financial legacy passes properly to the next generation.

In becoming an IRA beneficiary designation guru, Dave Polstra of Polstra & Dardaman, LLC, of Norcross, Georgia, learned that clients could suffer serious financial harm unless they pay attention to details on IRA beneficiary designation forms. Specifically, Polstra says, clients and advisors must pay closer attention to the fine print on IRA beneficiary designation forms.

With final IRA distribution regulations becoming mandatory in January, IRA beneficiary designation forms are about to be revised by many institutions, and advisors need to examine these forms to be sure the revisions are aligned with your customers’ interests. Creating a beneficiary designation form that is flexible and that protects IRA owners and their heirs could place greater administrative burdens on the IRA custodians. It also would cost money to implement, so the custodians in the past have not always created beneficiary forms giving IRA owners the best choices. Polstra has read the fine print on some of these forms and offers tips to advisors on this complex area.

What’s your beef with beneficiary designation forms? My main beef is that advisors take these forms for granted. So often they are filled out at the last minute, at the end of transactions, and many times there is not a lot of thought and care that goes into these papers.

While I want to focus your comments on IRA beneficiary forms, it’s probably not a bad idea to just touch on how IRA beneficiary designation rules overlap with estate planning. It is absolutely imperative that IRA beneficiary designations be coordinated with a client’s overall estate plan and other estate planning documents and with estate equalization. In estate equalization, you want an equal amount of assets in each spouse’s name individually to fund the estate tax exemption amount of $1 million per individual. When we have IRA assets involved, that task becomes difficult. For instance, take a retired couple where the man has $1 million in an IRA and the couple has $1 million of other non-IRA assets. The inclination is to put all the non-IRA assets into the other spouse’s name who does not own the IRA. People fail to realize that 11 out of 12 times the husband dies first. The problem is that if the husband dies first and he has named his wife as beneficiary of his IRA, his IRA goes directly to his spouse upon his death and his $1 million estate tax exemption is wasted. An alternative plan would have been for the IRA to have been made payable to a Credit Shelter Trust (CST). Or better yet, he could name his wife as the primary beneficiary of the IRA and add the CST as a secondary beneficiary. Upon the husband’s death, the wife could disclaim part or all of her husband’s IRA, and the IRA would pass to the CST. Since the wife is the primary beneficiary of the CST, she would get the benefits of the IRA. [Using] this strategy, her husband’s estate tax exemption would be fully utilized.

Disclaiming to a CST does have advantages and disadvantages. The advantage is that you can maximize estate exemptions; the disadvantage is that payouts from the trust will be based on the life expectancy of the surviving spouse. If she had done an IRA rollover and named her children as primary beneficiaries of the IRA, her children’s life expectancies are much longer. You need to run the numbers and see the best alternative.

If a wife is in excellent health and [is likely to] live a long time, I would be inclined to do an IRA rollover to ensure a long stretch-out for the kids. If the wife is in poor health, the disclaimer strategy taking full advantage of the husband’s estate tax exemption is better because the wife is likely not to live long enough for the stretched payout to make up for the loss of the estate tax exemption.

Keep in mind that we will now have a Republican Congress and that estate tax repeal may be made permanent. If repeal of the estate tax is accelerated, then utilizing the exemption becomes a moot point and clears up [many] planning issues. No matter what happens to the estate tax, income taxes will probably always be here and the ultimate goal of IRA distribution planning is defer, defer, defer. Assuming the beneficiary does not need the money to make living expenses, the longer you can stretch out payments, the better. Planners have to examine the issues to figure out what to write on IRA beneficiary forms.

How do you explain these complex issues to clients? We flow-chart it out. In working with estate planning attorneys for 20 years, I’ve seen that they are very word-oriented; they very often do not like numbers. What we help clients with is being able to take that net worth statement–which lists joint assets, individually owned assets, qualified plans, IRAs, and insurance policies–and then read their will and their IRA beneficiary designation form, and we chart it all out. The client and we can then see where all their assets flow upon their death. That creates a great discussion point when you sit down with an estate planning attorney. You can talk about retitling assets or changing beneficiaries on insurance policies or on IRAs. And it’s a great service for the client. Take, for instance, a client I have who was in a second marriage. He and his wife had an elaborate set of estate planning documents written by a major law firm in the Southeast. The documents were buttoned up and tight, but when we flow-charted how the assets would go to their heirs, he was shocked that his two vacation homes went outright to his second spouse when all along he thought they would go to a QTIP trust that would ultimately pass to his children. Flow charts can help planners explain these concepts to clients and avoid bad surprises for families.

And you’ve made a specialty of helping clients avoid surprises like that with IRAs. Right? Right. Big and bad surprises can occur when an advisor fails to understand the default provisions that are written into custodial agreements. In fact, I’d venture to bet very few advisors even read IRA custodial agreements. Clients are paying me to be their personal CFO and not just manage their money. When they pass away, I want to be sure their assets go where they thought they would. A typical example: One of the biggest problems in custodial agreements has to do with per stirpes versus per capita distributions. Most custodial agreements default to a per capita distribution. I’d venture to guess that many advisors do not check to see if the custodial agreements they give to clients to set up their IRAs use a per stirpes or a per capita distribution formula, even though this is of critical importance in beneficiary designation planning.

Explain why this is so important for planners to check. Say you have a 64-year-old widowed man, who has three grown children, each of whom is an equal beneficiaries of his IRA. Let’s say he also has three grandchildren, one for each child. Let’s say his middle child predeceases him, and, for whatever reason, he does not redo his beneficiary designation–maybe he did not think it was necessary or he just plain forgot. Then, he dies. How is that IRA distributed? The answer is that if the default provision on the beneficiary designation form is for a per capita distribution, then his two surviving children will split the IRA 50-50, and his grandchild from his deceased child is cut out of any IRA benefit. However, if the beneficiary designation specifies that the IRA is payable to his three kids in equal amounts per stirpes, then the deceased child’s share would automatically pass through the bloodline and the deceased child’s child would receive one third of the IRA, which could be distributed over the grandchild’s life expectancy if the accounts are segregated in a timely manner after his grandfather dies.

Are most of the custodial IRA beneficiary designation forms pretty much the same? No. We went back and randomly polled some custodial forms and they’re all different. For example, Fidelity Investments’ form defaults to a per capita distribution, but it does have a box to check to choose a per stirpes stipulation instead.

Merrill Lynch’s form, on the other hand, defaults to per capita distribution and there is no checkoff for per stirpes. Schwab also defaults to per capita distribution, and so does TD Waterhouse. And Waterhouse’s form is even more restrictive. If you have more than one primary beneficiary on a TD Waterhouse beneficiary designation form, then the TD form says payments will be made in equal proportions to all the beneficiaries. However, I’ve had many situations where someone wants to leave 40% of his IRA to a son, and 40% to a daughter and 20% to a church. The standard Waterhouse form does not allow for that.

What are some other issues advisors need to look for when helping clients with beneficiary designation forms? One issue that arises with these forms is the fact that a minor cannot legally own assets in an IRA. So if a minor is the beneficiary of an IRA, it needs to be paid out to the minor’s legal representative. We usually add language to our own custom-made form saying that if a distribution is made to a beneficiary who has not attained the age of 18 or the majority age in a particular state, then distributions from the IRA will be taxed similarly to other custodial assets held in the child’s names.

Another problem is when you have a nasty divorce. As soon as the divorce is finalized, the husband may change his will and remove his former spouse from his will. But the husband may not think of changing his IRA beneficiary designation. Ten or 20 years after the divorce–he has remarried perhaps by then–he dies, and lo and behold, the IRA is payable to his former spouse because he forgot to change his beneficiary designation. Probably the best IRA custodial agreement I’ve seen is from National Advisors Trust Company, designed by Sungard Corbel. It says that a divorce decree or legal separation decree revokes the IRA owner’s previous beneficiary designation of his former spouse as a beneficiary and eliminates that spouse from the beneficiary designation unless the divorce decree provides otherwise. The new spouse is by default the new beneficiary and then to his children per stirpes, and then to his parents, and then to his estate. This allows a maximum stretch-out of the IRA to his heirs.

I’m sure advisors who read about your suggestions are going to look at custodial agreements more closely. What else can they do? We’re about to see the revision of these forms by many institutions. Because the IRA regulations have now been finalized, and using them is required beginning in January 2003, all custodians are updating their IRA custodial agreements to be in compliance with the new regs, and this provides a great opportunity for them to also update their IRA beneficiary designation forms.

For instance, Schwab’s form defaults to a per capita distribution. However, it is coming out with new forms in mid-November that comply with the new regs. We don’t yet know if the new forms will allow a check-the-box per stirpes option. Getting the IRA custodians to change their forms to give more flexibility to their clients would be good for advisors. Many times the custodians don’t want to do this because they incur legal fees in changing the forms. So we take a second approach, and we have our client write on the beneficiary form, “See attached.” And, with the help of a law firm, our firm uses custom beneficiary forms for the client that are signed and witnessed, and we get a signed copy from the custodian acknowledging receipt. It adds the language assuring a per stirpes distribution.

You can also add language to a custom beneficiary designation form allowing beneficiaries of an inherited IRA to name a successor beneficiary. If the beneficiary of an inherited IRA dies, some custodial agreements require that the IRA be paid in a lump sum to the estate of the beneficiary. That’s not a good thing. Many inherited IRAs allow a beneficiary to name a successor beneficiary, so the stretch-out can continue over the remaining life expectancy of the de- ceased beneficiary. If the original beneficiary dies at age 60, for instance, and there are still 20 years of payouts left, then the successor beneficiary can continue to stretch out distributions over that 20-year period remaining even after the death of the beneficiary. Some custodial beneficiary forms allow for a successor beneficiary on their inherited IRA form. That successor form is only filled out when you inherit an IRA.