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Disaster-avoiding strategies for retirement beneficiaries

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Most clients name the beneficiaries for their retirement savings plans with careful consideration and in good faith. And most of the time, that’s a safe and easy thing to do, with little opportunity for disaster.

But there is one mistake that is easy to make and seems so harmless the client might not even mention it, though the error could result in hardship and risk of asset loss for the client’s heirs. And it’s such an easy decision that some unsuspecting clients may tick off that box without realizing they should have discussed it with you.

The problem: leaving a retirement account — an IRA or a 401(k) — directly to one’s estate. An unsuspecting client could easily make that decision; and it can even happen accidentally.

The first concern is that any money left to an estate will probably require a probate proceeding in order to be distributed. The probate court would consider that asset to be part of the estate after the client dies. Administering and distributing those assets could take months or even years to wend its way through that process.

But that’s not the only issue with leaving those assets to an estate. When a 401(k) or IRA is left to a spouse or children, that money goes directly to them and is well-protected. But when the money is left in an estate, and thus has to pass through the probate court, it is first exposed to creditors.

If the client dies with $500,000 in medical bills, the 401(k) left directly to a child is unaffected. But a 401(k) left to an estate would be used to pay those debts. Any such outstanding debts could infringe on or even wipe out the retirement plan the client has spent years building up.

There’s another issue affecting IRAs that makes the estate designation a mistake. Anyone other than a spouse who inherits an IRA can roll those assets over to a stretch IRA: a vehicle in which assets continue to grow tax-deferred, although the beneficiary will also be required to take out a required minimum distribution (RMD) each year. With an IRA left to an estate, though, that’s not an option. What’s more, taxes will be due on an IRA left to an estate. If the account is left to individuals other than a spouse, they can choose to liquidate the account; and they have five years in which to pay the taxes on those assets.

The advantages of a stretch IRA are also lost if the client names a revocable trust as the primary beneficiary for a retirement account. The rollover option is only available if a person inherits the account. Naming the client’s spouse as the beneficiary allows for rolling the proceeds of the inherited IRA over to the spouse’s own IRA upon the client’s death.

So it should be obvious to both advisors and clients that the designation for a retirement account should be considered carefully and approved by a financial professional. But there are ways that an IRA can fall into a client’s estate by accident as well. Some of the inadvertent ways this can happen:

  • If the client fails to designate a beneficiary for an IRA, it automatically falls to the estate. It’s important to double-check long-held accounts that may have been opened before the client was even thinking about beneficiaries. This isn’t necessarily the case with a 401(k); if no beneficiary is named, the account automatically goes to a surviving spouse. But if the decedent is unmarried, the 401(k) passes to the estate.
  • If the beneficiary the client has designated for an IRA has already died, the account also is assigned to the estate. This can be avoided by naming contingent beneficiaries, but it also points up the importance of conducting a full estate plan review upon any major life change, such as the death of a close family member.

The good news is that these issues are easily avoided with a simple review of beneficiaries for all retirement accounts. Similar reviews can take place for life insurance and other accounts as well. And your clients will appreciate you helping them avoid disaster.

See also:

Early 401(k) withdrawal replaces homes as America’s piggy bank

5 facts to know about retirement plan rollovers

Retirement caps: a plan that could save billions in tax revenue


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