The Perils and Pitfalls of IRAs

I get questions on this topic all the time…

Most people are surprised to learn that their will or trust does not control who inherits their IRA. Retirement accounts such as IRAs and 401(k)s pass according to the beneficiary designation form on file with the financial institution. If your will says, “I leave my IRA to my daughter,” but your IRA form names someone else, the IRA form wins every time. Because of this, beneficiary designations are one of the most important — and most overlooked — parts of an estate plan.

You have several options for who can inherit your IRA. Many people name their spouse, others name their adult children, and some use a trust to manage the assets for their beneficiaries. Each choice comes with pros and cons. 

• Naming a spouse is often tax-advantageous because a surviving spouse can roll the account into their own IRA and delay required minimum distributions.

• Naming adult children is simple, but under the SECURE Act, most adult children are required to withdraw the entire account — and pay taxes on those withdrawals — within ten years of your death.

• Minor children can also be named, but they cannot legally manage the funds; depending on the state, they may receive full control at age 18 or 21, which may not be ideal. 

• For families who want to protect beneficiaries from spending too quickly, who have blended family dynamics, or who have a beneficiary with a disability, naming a trust as the IRA beneficiary can provide structure and protection. However, the trust must be drafted with specific retirement-account language; otherwise, withdrawals can be forced out more quickly, creating unnecessary taxes.

  
  

Under the SECURE Act, the general rule is that most non-spouse beneficiaries must withdraw (and pay income taxes on) the entire IRA within ten years of your death. A few categories of beneficiaries — including spouses, disabled or chronically ill individuals, and minor children (until they reach legal adulthood) — are permitted to stretch withdrawals over a longer period. Everyone else, particularly adult children who inherit IRAs during their peak earning years, may find themselves paying more tax than expected.

Where you live also matters. Oregon is a separate property state, meaning you can generally name anyone you choose as beneficiary on an IRA without needing spousal consent. Washington, on the other hand, is a community property state, which means that retirement assets earned during the marriage are presumed to belong equally to both spouses. In Washington, if you want to name someone other than your spouse — such as children or a trust — the spouse may need to sign a written consent acknowledging that decision. Without that consent, a surviving spouse in Washington may challenge the beneficiary designation after death.

For 401(k)s, there is an additional rule that applies no matter which state you live in. Federal law (ERISA) provides that the spouse is automatically the primary beneficiary of a 401(k) unless they sign a notarized waiver allowing someone else to be named. Even in Oregon, where spousal consent is not required for IRAs, it is required for 401(k)s.

Many people assume they should “put their IRA into their trust.” That is not how retirement accounts work. You do not retitle the IRA into the trust while you are alive. Instead, you simply list the trust as the beneficiary on the beneficiary form. That way, if the trust needs to control how funds are distributed — for example, to keep a child from receiving a large lump sum all at once — the trust receives the IRA upon death and dictates how the withdrawals flow to the beneficiaries.

Furthermore, the simplest route can simply be to name high functioning adult kids as the beneficiaries of and IRA and avoid the trust completely. Sometimes, simple is better. As with most things, “it depends.”

If you have not reviewed your beneficiary designations in the last year or two, now is a good time — especially if your family has changed due to marriage, divorce, a new child, or if you have created a trust and never updated the IRA to reflect the new plan. Retirement accounts often represent a significant portion of a person’s total estate, and making sure the right people inherit them is a small step that prevents major problems later.

You worked hard to build these accounts.Let’s make sure they go to the right people.

List of the Most Common Mistakes With IRA Beneficiary Designations

Even thoughtful estate plans can unravel if beneficiary designations are outdated or filled out incorrectly. Here are some of the most frequent — and preventable — mistakes:

1. Forgetting to update after life changesThe most common error is leaving an ex-spouse or deceased person listed as beneficiary. Financial institutions are legally required to follow the form on file, even if your will or trust says something different.

2. Naming minor children directlyAssets left outright to minors often end up in court-supervised conservatorships, and children may gain full control of the funds at 18 or 21. A trust or custodial structure usually works better.

3. Listing your estate as beneficiaryThis causes the IRA to go through probate and eliminates tax planning options, often forcing faster withdrawals and higher taxes.

4. Assuming “my trust has me covered”IRAs and 401(k)s don’t flow automatically into your trust unless the trust is named as beneficiary. Your estate plan may be beautifully drafted — but if the beneficiary forms don’t match the plan, the plan fails.

5. Not getting required spousal consent (especially for 401(k)s)For IRAs in Washington, spousal consent may be required because of community property laws. For 401(k)s everywhere, spousal consent is required under federal law if you name anyone other than the spouse.

Coming Next Time: An intro to Donor Advised Funds

I’ll be writing about Donor Advised Funds (DAF) in my next newsletter, but it’s worth introducing them now in relation to the inheritance of IRAs.

One of the quirks of estate planning is that an IRA is often the least tax-efficient asset to inherit. When children or other non-spouse beneficiaries receive an IRA, they are required to withdraw the entire balance — and pay income tax on it — within ten years. If they happen to inherit the IRA during their peak earning years, those withdrawals can push them into higher tax brackets, which means a significant portion of that retirement account ends up going to the IRS instead of to your family. No kidding, inheriting an IRA could mean actually receiving $0.25 on the $1.00.

 Compare that to a taxable investment account, which may receive a step-up in basis at death, or real estate, which offers far better tax treatment for heirs. IRAs tend to be the asset that triggers taxation the fastest and the hardest.

However, what is not ideal for heirs can be powerful for charitable giving. A DAF allows you to name the fund as the beneficiary of some or all of your IRA at death. When the IRA transfers to the DAF, no one pays income tax on that IRA — not your estate, not your heirs, not the charity. The assets then sit inside the DAF, where your family (as successor advisors) can recommend grants to charities over time. In other words, your heirs receive the tax-preferred assets, and the IRA — the most heavily taxed asset — becomes the fuel for charitable impact. It’s a simple way to remove taxes from the equation and leave a charitable legacy without reducing what passes to family.

Anyway, more about this next time.