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Choose beneficiaries carefully

By Jennie L. Phipps ·
Monday, February 21, 2011
Posted: 10 am ET

I have this terrible retirement planning fear that I have somehow overlooked changing the beneficiary on some old retirement account and it will inadvertently become the property of my ex-husband.

Beneficiaries supersede wills and trusts, so paying attention to them is a key part of estate planning. Giving thought to choosing the right beneficiary is particularly important with an IRA because there are significant tax consequences, points out John P. Dedon, a trust, estate and tax attorney at Odin, Feldman & Pittleman in Washington, D.C.

Dedon says if an IRA owner doesn't choose a beneficiary for his IRA, it becomes subject to the IRS' five-year rule. The person who inherits the IRA must take all the money out of the plan and pay taxes on it within five years of the death of the owner. If you name the person who inherits the money the beneficiary, then that person can allow his IRA inheritance to grow tax free for many years, taking only minimal distributions and tax payments over his lifetime. That definitely increases the value of your gift.

If you are planning to leave your IRA to an offspring who is a spendthrift or a spouse who might be tempted to cut children from your first marriage out of her will, you can make a qualified trust -- not a person -- your beneficiary. This allows you to combine the benefits of a stretch distribution plan with asset protection, Dedon says.

You don't have to be wealthy for this kind of estate planning to make sense. Even people leaving behind modest IRAs choose trusts to make sure their loved ones are protected and treated fairly. Setting up a trust isn't usually a do-it-yourself project, but the cost isn't prohibitive -- often less than $1,000.

At the very least, don't neglect to update the beneficiaries on your retirement accounts. Being nice to your ex is one thing -- leaving him your hard-earned savings is quite another.

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1 Comment
March 04, 2011 at 5:27 pm

If there is no beneficiary named on an IRA, the 5 year rule doesn't necessarily apply. It depends on what the custodian/sponsors adoption agreement says. Old documents will say the money will go to the estate and the IRS 5 year rule will apply. Other old documents say the 5 year rule will not apply and it will get settled in probate court.

Regardless though, nowadays most custodians have opted for a default designation which will usually follow the state probate code of the domicile of the custodian UNLESS the person actually writes “estate” on the application. I am not sure why anyone would. Even if you opened the IRA 20 years ago, this new default will apply to you since the custodian has to maintain these contracts with the IRS across all participants. So, if you opened an IRA with the largest custodian in the world (I won’t name them here) in 1988 and left the beneficiary section blank, your account will go directly to your spouse. If you don’t have a spouse at the time of death, it will be split directly among your children. If you don’t have children, it will be split directly among your grandchildren. (Most state probate code goes spouse then lineal decedent.) Get it?