YOU RETIREMENT PLAN, NOT YOUR WILL, CONTROLS THE DISTRIBUTION
If you fail to complete and sign a beneficiary designation form for a retirement account you own, then the terms of what is called the “custodian agreement” or “plan agreement” will dictate by default where and how your retirement plan benefits will be distributed when you die. Every retirement account you own will has, in addition to the beneficiary designation form, a contractual agreement between you and the entity that is responsible for holding and, in some cases, managing your retirement plan assets. These custodial or plan agreements specify who will receive your retirement plan assets when you die if you fail to have signed a beneficiary designation form. In most cases, the result will not reflect your wishes or unique family situation.
FAILURE TO DESIGNATE BENEFICIARIES CAN BE COSTLY
As a rule of thumb, whenever your estate is the beneficiary of one of your retirement accounts, at least 1/3 of that retirement plan account balance at the time of your death will be lost due to income taxation of your entire retirement account balance and payment of outstanding debts. This percentage can be much higher for some families. In many cases, this loss can be easily prevented simply by making sure you have completed and signed proper beneficiary designations for every retirement account you own prior your death.
WHAT IS “STRETCHING AN IRA” AND WHY IS IT IMPORTANT?
Unfortunately, the IRS has promulgated special distribution rules to prevent families from leaving money in a Qualified Plan or IRA over multiple generations, which would not be subject to taxes. These rules, govern when and how funds must be distributed from IRAs and Qualified Plans. Understanding the nuances related to these rules could save your family from paying significant unnecessary taxes.
YOU MUST WITHDRAW ON A CERTAIN DATE (USUALLY WHEN YOU ARE 70 ½)
Of course, an owner of participant can make early withdrawals at any time prior to the Required Beginning Date. In general, withdrawals can occur as early as the plan participant/IRA owner turning age 59 ½ (without penalty or at anytime with a 10% penalty.
THE IRS RULES DETERMINE THE AMOUNT OF REQUIRED DISTRIBUTIONS
THE PERIOD OF TIME TO MAKE DISTRIBUTIONS (LIFE EXPECTANCY)
As long as the plan participant or IRA owner is living, the determination is made from an IRS table which uses his or her age in the year the distribution is to occur and his or her life expectancy. However, if the plan participant/IRA owner dies before his or her interest in the Qualified Plan or IRA is entirely distributed, the maximum distribution period will depend on (i) whether the plan participant / IRA owner
died before or after the required beginning date; and (ii) whether he or she named a designated beneficiary for the remainder of the interest.
Life Expectancy if Death Occurs Prior to Required Beginning Date
In the absence of Qualified Plan or IRA provisions to the contrary, the balance of the plan participant/IRA owner’s interest can be distributed over the life expectancy of the Designated Beneficiary. If there are multiple Designated Beneficiaries, the shortest life expectancy will be used.
If there is no Designated Beneficiary the balance of the owner’s interest must be distributed in full by December 31 of the fifth year after his or her death, thus incurring tax unfavorable consequences. This is known as the “Five Year Rule.”
Whether a life expectancy or the Five Year Rule is used Required Minimum Distributions must begin by December 31 of the year after the owner dies. There are special rules in the case a surviving spouse is named as a Designated Beneficiary.
Life Expectancy if Death Occurs After Required Beginning Date
STRETCH AN IRA OR QUALIFIED PLAN FOR TAX BENEFITS
For this to work, the deceased must have completed a beneficiary designation form and properly re-titled the Qualified Plan or IRA. Incorrectly re-titling what remains of the owner’s interest can be a costly mistake – as the IRS could deem this action as a lump sum distribution to the beneficiaries. If the interest is deemed to be distributed the stretch – and the related tax savings – is lost.
There are other complex rules related to the spouse as a beneficiary (including rules related to rolling the Qualified Plan or IRA into the Qualified Plan or IRA of the surviving spouse) and designating multiple beneficiaries that are beyond the scope of this brief summary.