Is there a difference between a beneficiary and a designated beneficiary? Yes!
Beneficiary vs Designated Beneficiary
A beneficiary can be any person or entity, but not all beneficiaries are designated beneficiaries.
A Designated Beneficiary
A designated beneficiary is a person (or group of people) with a life expectancy who is named on the beneficiary form. This means individuals…living, breathing people who can celebrate birthdays. Individual beneficiaries of qualifying trusts will also be treated as designated beneficiaries for IRA distribution purposes. An estate and a charity are not designated beneficiaries and have no life expectancy. Their life expectancy is zero.
Estate as Retirement Plan Beneficiary
When we talk about using the estate tax exemption, we do NOT mean to name the estate as the retirement plan beneficiary. As a general rule, never, ever name the estate as a retirement plan beneficiary, but so many people do. Why? Many times they are told,”Just name your estate and your retirement plan will pass through the provisions of your will and go to all the right people.” That statement may be true, but it should have been changed to say, “It will go to all the right people; that is, whatever is left after taxation of 70% or more.” Why? Because the estate is not a designated beneficiary, which means it has no life expectancy. For maximum IRA stretchout, you need to make sure that your client has a designated beneficiary.
Another way the retirement plan can be left inadvertently to an estate is where no beneficiary is named at all. If there is no beneficiary for the retirement plan, the estate may become the beneficiary by default, even though the client thought he named somebody. If the estate becomes the beneficiary for whatever reason, then the IRA stretch option is lost.
When the estate is named as the IRA beneficiary, the retirement plan, which is usually a non-probate asset because it has a beneficiary form, is turned into a probate asset. Anything that passes through the will becomes a probate asset. Not only would the tax ramifications be expensive, but the estate would be subject to any probate costs on the retirement plan. If there is a large retirement plan, that could be a substantial amount of money, maybe even up to 5% in some cases, depending on lawyer’s and court filing fees.
If a client dies without a will, in other words, dies intestate, then the entire retirement account passes to beneficiaries through the intestacy laws of the state. This may not be the choice that the client had in mind for beneficiaries. It could also get dragged out in a contest if certain beneficiaries come out of the woodwork and claim to be the rightful heirs to this retirement plan. Most, or all, of it could get eaten up in legal fees.
Estate Becomes the IRA Beneficiary Because the Beneficiary Form Wasn't Updated After the Will Was Revoked
The testamentary trust under the will was the IRA beneficiary. However, that will was later REVOKED, but the beneficiary form was never updated before death.
The custodial agreement default provision states that the estate becomes the beneficiary.
Result: No designated beneficiary.
The deceased IRA owner’s wife was the sole beneficiary of all of her husband’s estate, including the IRA.
In this PLR (Private Letter Ruling), the wife (the surviving spouse) requested that she be permitted to do an IRA rollover (a spousal rollover). IRS granted the ruling and approved the rollover, fixing the problem.
From the PLR:
“Taxpayer B revised the Year 1 Will on Date 4 (Year 2 Will) to eliminate the testamentary trust and to pass his entire estate to Taxpayer A free and clear of the trust. The revision updated and revoked the Year 1 Will in its entirety, but did not update the IRA X beneficiary designation form which listed Taxpayer A as beneficiary of the testamentary trust. Under the Year 2 Will, Taxpayer A was the sole personal representative of Taxpayer B’s estate and was the sole beneficiary of IRA X.”
“In the present case, Taxpayer B’s interest in IRA X did not pass to the trust that was listed on the IRA beneficiary designation because the Year 2 Will revoked the trust. Thus, in the absence of a designated beneficiary the IRA X account balance remaining at Taxpayer B’s death became payable to his estate. Because Taxpayer A was Executrix and sole beneficiary of the estate with the right to direct any and all amounts from the estate without restriction, Taxpayer A could have demanded, in writing, that the full IRA X balance be paid to her. Under this set of circumstances, no third party could have prevented the surviving spouse from rolling over, or transferring, by means of a trustee-to-trustee transfer, the full amount standing in IRA X into an IRA set up and maintained in the surviving spouse’s name.”
The IRS fee alone for this PLR request was $10,000, plus professional fees, not to mention the cost of the will and trust set up that was revoked. All of this was because a beneficiary form was not updated.
Hopefully, someone advised this spouse that she should immediately name beneficiaries on this new IRA, so that her beneficiaries will be permitted to stretch the IRA over their lives.
Charity as Beneficiary
For individuals who are charitably inclined and have made provisions for certain charities under their will and also have substantial retirement plans, an effective tax strategy would be to reverse the bequests. Revoke the old will and execute a new will, leaving the funds that were going to go to the charity to the family instead, and make up the difference by leaving the same amount of retirement plan money to the charity.
This way, the charity receives the same amount that they were going to receive in the will, but the heirs will end up with more because the money they will inherit will not be subject to income tax, as the retirement plan would be.
Split IRAs. Do not name a charity as a co-beneficiary on a retirement plan. The charity does not have a life expectancy. The charity is not a person so its life expectancy is “0” (zero). Therefore, if you name a charity as a beneficiary with any other person, automatically the other person reverts to a “0” life expectancy. To offset this, the living beneficiaries need to be sure the charity is paid out by September 30th of the year after the IRA owner’s death or that the account is split into separate accounts by that date with the charity having its own account. This way, the remaining designated beneficiaries (those with a pulse and breathing) get to use their own life expectancies in calculating required distributions. It is still best to keep charitable beneficiaries on separate IRAs, with no other co-beneficiaries.
Disclaimer planning with charitable beneficiary
Name the charity as the secondary beneficiary. This way, upon death, the primary beneficiary can disclaim any portion he or she wants to go the charity.
Spouse as a Beneficiary
The spouse beneficiary can roll over or transfer her deceased spouse’s retirement plan into her own IRA. A spouse who is the beneficiary of an IRA can also elect to treat it as her own IRA. Only a spouse can do a rollover or make this election. If the decedent was in pay status, the year of death required distribution has to be taken before a rollover is permitted. However, an RMD can be transferred (trustee-to-trustee) to another account and taken later in the year. A retirement plan can be rolled over or transferred by a spouse regardless of whether the retirement plan owner died before or after the RBD (Required Beginning Date). If the spouse chooses the rollover, the IRA will be treated as the spouse beneficiary’s own IRA. Distributions to the spouse prior to her age 59½ will be subject to the 10% early distribution penalty and RMDs will begin at the surviving spouse’s age 70½.
Spouse as Beneficiary of Retirement Plan (no rollover)
A spouse can also be treated as a retirement plan beneficiary. This is different than a spousal rollover.
If the spouse chooses to remain a beneficiary (instead of rolling the IRA over or treating it as her own), she will have to take beneficiary payouts based upon her life expectancy, recalculated if she is the account’s sole beneficiary. The payments start in the later of the year after the year of the account holder’s death, or the year the account holder would have attained age 70½. The age 70½ option is only available if the spouse is the sole beneficiary. Under the Regulations, if there are multiple individual beneficiaries at death, the account may be split into each beneficiary’s share, so that each beneficiary is the sole beneficiary of that share.
Assume that Frank dies before his RBD, at 68, and named his spouse, Barbara, as IRA beneficiary. Barbara is 65 years old. She has two choices. She can either be a direct beneficiary or use a spousal rollover and treat the IRA as her own. If Barbara chooses to be a direct beneficiary, she does not have to begin taking distributions until December 31 of the year that Frank would have attained age 70½. If Barbara chooses a spousal rollover, she treats it as her own IRA and would not have to begin taking distributions until the year she attains age 70½. In most cases, it would be beneficial to use the spousal rollover.
It would pay to be treated as a beneficiary only where the spouse was much younger. If instead of 65 years old, Barbara was 40 years old and did a spousal rollover, the account would be treated as her own IRA. If she wanted to take any money out before age 59½ there would be a 10% penalty which is assessed on retirement plan owners who tap into their retirement plan accounts before age 59½. But this 10% penalty does not apply to retirement plan beneficiaries. In this case, where the beneficiary is much younger than 59½ years old (40 years old), it would pay to be treated as a beneficiary and the surviving spouse could take distributions without incurring the 10% penalty. After reaching age 59½, the spouse still has the rollover option available. Choosing to remain a beneficiary does not restrict the spouse from being able to roll over later on.
It might also pay to use the beneficiary route if the surviving spouse was much older, for example, 75 years old, and the retirement plan owner was 65 years old. If the surviving spouse chose to be a beneficiary, they would not have to start drawing until the year the retirement plan owner would have attained age 70½. Even though the surviving spouse is 75 years old, he or she would not have to draw down for another five years as opposed to choosing the spousal rollover which would mean they would have to begin withdrawals by December 31st of the year following death.
If the spouse is named as the retirement plan beneficiary, when the retirement plan owner dies the spouse should immediately name new beneficiaries. If the surviving spouse dies before doing so, the beneficiary will generally be the estate and then all chances of extending the life expectancy by naming younger beneficiaries will be lost.
Non-Spouse as Retirement Plan Beneficiary
A non-spouse is any other entity or person who is not the spouse of the retirement plan owner, for example: child, grandchild, brother, sister, parent, friend, trust, estate, charity. But only a person named on the beneficiary form can be a designated beneficiary and entitled to the stretch IRA. So from the list above, the trust, the estate and the charity are not designated beneficiaries. The trust could be a designated beneficiary if the trust qualifies under the various IRS rules.
A designated beneficiary can extend post-death payouts over the designated beneficiary’s life expectancy. The identity of the designated beneficiary to take post-death distributions is not determined under the rules until September 30 of the year after the year of the account holder’s death. This will give beneficiaries and financial institutions an added
three months to calculate and withdraw required amounts by December 31st of the year following the year of the owner’s death.
This does not mean that a designated beneficiary can be named after the death of the IRA owner. The IRA owner must name all designated beneficiaries, both primary and contingent, while he is still breathing. Then, after death, the designated beneficiary may be changed, but only amongst the group of beneficiaries named by the IRA owner. A beneficiary named through an estate can never be a designated beneficiary.
Death During the “GAP” Period
Since the designated beneficiary is not determined until September 30th of the year following the year of the IRA owner’s death, a so-called “GAP” period is created. The gap period begins on the date of death and ends on September 30th of the following year. The 2001 Proposed Regulations created this gap period concept, but it raised the question of what would happen if the beneficiary died during the gap period.
The Final Regulations answer this question by stating that the life of the deceased beneficiary will be used if that beneficiary dies within the gap period. The September 30th date also allows for planning by using disclaimers, post-death distributions (cash-outs), and account splitting by beneficiaries. But the beneficiary designation form has to be properly set up to handle this. Otherwise the retirement plan could end up in the estate if disclaimed.
If there are multiple beneficiaries, the inherited account can be split after death. Each beneficiary can use his own life expectancy from the single life table for figuring required distributions, but that split should be done by September 30th of the year following the year of the IRA owner’s death. The tax code actually gives you to December 31st of the year after the IRA owner’s death to do the split. If the account is NOT split by then, the shortest life expectancy is the measuring life. The lifetime payout (the stretch IRA) is the default. The lifetime payout is based on the life expectancy of the designated beneficiary in the year after the year of the account holder’s death, and is decreased by one each year thereafter.