Leaving the Wrong Beneficiary on Your IRA Plan Can Be a Costly Mistake: Many savers pay little attention to retirement-account beneficiaries

Even if nothing has changed but the account owner’s age, that could matter. It may be clear now—as it wasn’t 10 years ago—that Grandpa will be leaving a larger traditional IRA than expected.

In that case, naming his grandchildren as secondary heirs could provide flexibility at his death. Or if Grandma’s tax rate is low compared with her children’s rates because they’re in peak earning years, perhaps a Roth IRA conversion could lower withdrawal taxes on the family as a whole.

“People pay attention to their wills when they sign them, but they fill out IRA and 401(k) beneficiary forms without thinking—and then forget about them,” says Bruce Steiner, an estate lawyer with Kleinberg, Kaplan, Wolff & Cohen in New York who specializes in retirement-benefits planning.

This is a mistake. Retirement accounts, unlike some financial accounts, typically don’t pass to heirs based on will provisions. Instead, they pass based on beneficiary forms filled out by the owner. While many problems with these forms can easily be solved while the account owner is alive, that’s not true after death.

“Once an owner dies, beneficiary forms are much harder to fix than trusts. Often a fix is impossible,” says Natalie Choate, a lawyer-turned-writer in Boston specializing in retirement accounts.

Of course, other financial accounts with banks or brokers can have beneficiaries, so check them too. But often mistakes aren’t as costly, and naming beneficiaries for them can complicate estate planning.

Professionals in this field see costly errors. Steiner had a major U.S. bank lose a client’s IRA beneficiary form and refuse to honor a copy—even though he provided evidence he sent it to the bank.

Choate knew a young professional who made his sister the heir of his tiny retirement account. When he died years later without changing the form, the plan was his largest asset. But his sister inherited it, not his wife and children.

My own story in this area has a happier ending, but it shows how faulty memory can be. While reporting this column, I congratulated myself that all was in order with my beneficiary forms. Yet when I checked, my 401(k) plan listed no heirs.

I fixed that, but I endorse Choate’s warning to “go look at those forms you signed—or didn’t sign—20 years ago.” Here are issues to keep in mind.

*Don’t name your estate as heir. A retirement account’s heir typically must be a person (or a trust benefiting a person) for the heir to reap valuable tax deferrals like a spousal rollover or a 10-year payout of the proceeds. If the owner’s estate is the beneficiary instead, the account may have to be paid out fully.

*Designate more than one layer of heirs. In addition to primary beneficiaries, name secondary or “contingent” ones who can inherit if the first ones can’t or don’t want to.

This move helps if a primary heir dies, and it also provides flexibility by allowing so-called disclaimers. Say the first heir is an adult child who is already in a high tax bracket. Using a disclaimer, he could reject all or part of the account and have it go instead to the contingent heir, such as a child in a lower bracket.

If there’s more than one beneficiary, be crystal clear about the percentage for each.

*Complete new forms when transferring an account. Choate says many beneficiary errors arise when an owner moves a retirement plan from one sponsor to another, such as switching an IRA from Fidelity to Vanguard or vice versa, or rolling a 401(k) into an IRA. In that case, the beneficiary forms likely won’t transfer, so the owner needs to complete new ones.

*Understand the 401(k) waiver for spouses. Under federal law, spouses must be the heirs of a 401(k) plan unless they have signed a form waiving this right.

Say an employee remarries after her first husband dies. She wants her children to inherit her 401(k) and names them on the beneficiary form but neglects to get a waiver from her current spouse. If she dies with the 401(k), her spouse will inherit the account—not her children.

*Beware of divorce effects. Many states have laws that revoke provisions affecting the ex-spouse after a couple divorces, and some states have such revocations for IRA beneficiaries. However, says Steiner, beneficiaries for 401(k) plans can’t be revoked by state laws because they’re governed by federal law (see item above).

As a result, couples who split up should complete new forms or risk bad outcomes.

*Know how defaults can help or hurt. IRA and 401(k) sponsors often have a list of heirs, called defaults, in case the account owner didn’t name anyone. Often spouses come first, followed by children, parents, siblings and the estate.

This cuts two ways. If Mary wanted her husband Jack to have her IRA but didn’t name a beneficiary and the sponsor’s first default is to a spouse, then Jack may be able to inherit the IRA without a problem.

However, a 2012 decision by a U.S. Appeals Court in the case of Herring v. Campbell ruled against the estate of an employee who wanted two beloved stepsons to inherit his $300,000 401(k) plan. The employee didn’t list a contingent heir or change the beneficiary after his wife died, and the company’s list of eligible heirs if no beneficiary was named didn’t include stepsons. The funds went to other family members.

*Be careful with trusts. Trusts can be the beneficiaries of retirement accounts, and owners with large accounts and complicated families often choose them. Both specialists warn of a problem: Too often the account owner and advisers carefully devise a trust—then forget to name the trust as beneficiary.

Source: WSJ