IRAs and retirement plans often make up a substantial portion of a person’s net worth, so paying attention to the beneficiary designations directing their flow at death is crucial to successful estate planning.

One of the most confusing parts of creating a solid estate plan is how to name beneficiaries of qualified retirement assets, such as an individual retirement account (IRA) or an employer’s 401(k) plan. Each person’s needs are different and special circumstances may apply, but there are a few general rules to follow:

Rule #1: Designate a beneficiary.

First, beneficiary designations dictate where IRAs and 401(k)s go—a Last Will and Testament does not control them. The U.S. Supreme Court reinforced this point earlier this year when it awarded the first wife of a deceased member of the Kennedy family all of the benefits from his 401(k) plan. What was the Court’s logic? She was the designated beneficiary, and even though he had divorced her and changed his will, he had not bothered to change his beneficiary designation. For that reason, the plan was obligated to pay her the benefits he had accumulated in decades of service to his employer.

The second reason to make sure you designate a beneficiary is tax-related. Individual beneficiaries are entitled to stretch out the taxable distributions from a traditional IRA over a number of years roughly equal to their remaining life expectancies. If you fail to designate a beneficiary, then your estate may be required to withdraw the IRA funds (and pay the associated income tax) over only a five-year period.

Rule #2: Choose adults as beneficiaries.

One common mistake people make when designating IRA beneficiaries is naming minor children as beneficiaries. Minors are unable to claim benefits in their own name, and so if they are the named beneficiaries in an IRA, a conservatorship account will have to be established to hold those assets. A conservatorship account is not only time-consuming and expensive to create, it must be invested in CDs or equally secure investments. Additionally, conservatorship funds must be distributed to a child when that child turns 18, which makes it difficult to ensure that the funds will be spent for college.

Rule #3: Be careful when naming a Trust as beneficiary.

Instead of a minor child, a Trust should be named to hold the assets of an IRA for a minor’s benefit. However, the designation of a Trust as beneficiary raises another set of issues. For a Trust to allow its beneficiaries to stretch the distributions out over time, it must contain provisions that qualify the Trust as a ‘conduit’ Trust. Additionally, if there are multiple beneficiaries of a Trust, then the Trust must make distributions from the IRA on a schedule set by the oldest beneficiary.

The Final Word:

IRAs and retirement plans often make up a substantial portion of a person’s net worth, so paying attention to the beneficiary designations directing their flow at death is crucial to successful estate planning. Given recent changes in the laws in this field, it is a good idea to seek advice from your attorney or financial advisor to make sure your goals are met.

by Christopher Miller

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Chris Miller is an Alpharetta attorney. Contact him at 770.817.4999 or cmiller@robinsonmiller.com.