Designating Beneficiaries for Retirement Accounts, Part I
A beneficiary designation form is a simple and accessible tool that allows donors to make testamentary charitable gifts and streamline the administration of their estates. A beneficiary designation is a way to transfer an asset to an individual, organization or multiple beneficiaries upon the owner's passing. For financial accounts such as individual retirement accounts (IRAs), a beneficiary designation is typically a paper or electronic form provided by the account custodian, which allows the account owner to designate who will receive the asset upon his or her passing.
Beneficiary designations are an excellent way for donors to make estate gifts directly to nonprofits and to fund planned giving vehicles such as charitable remainder trusts and charitable gift annuities for a loved one. However, donors may not be aware of this benefit. Many individuals assume their retirement accounts will simply become part of the plan created by their will or trust. In many cases, directing a retirement account to pass through a will or a revocable living trust introduces unnecessary complexity and may disadvantage the intended beneficiaries. Fortunately, donors have a simpler option available for passing on their retirement accounts that will help fulfill their charitable intentions. Professional advisors can play a crucial role by offering a holistic approach to estate planning, which should include a discussion of beneficiary designations.
This article series will focus on the role of beneficiary designations in testamentary transfers of retirement accounts. This first article will explore the logistics of using beneficiary designation forms and compare this method to other testamentary transfer mechanisms. The second article in this series will examine how retirement account beneficiary designations can benefit both family and nonprofits. The third article in this series will discuss best practices for nonprofits when accepting gifts of retirement accounts transferred via beneficiary designation.
Probate and Non-Probate Transfer Methods
Many donors who are learning about estate planning for the first time are cautioned to "avoid probate," but many do not understand why or what that entails. Probate is a court-supervised administration process that takes place when a person passes away. This process is used to carry out the terms of a person's will, or to manage the estate of a person who passed away without having one. Probate is intended to settle a decedent's debts and transfer his or her assets to heirs. If an asset is owned by an individual in his or her individual capacity, typically, the asset must be transferred through the probate court after the owner passes, absent further planning.
However, not all of a decedent's assets are required to go through the probate process to be transferred to beneficiaries. If it is possible to bypass probate court administration with respect to a certain asset, there is the potential to avoid administrative and legal fees that might otherwise reduce a beneficiary's share and to deliver those assets to the beneficiaries in a shorter time frame. There are three common ways a person's assets can avoid being subject to probate upon his or her passing: joint tenancy with a right of survivorship, trusts and beneficiary designations.
Joint Ownership with Right of Survivorship
One form of ownership that avoids probate court administration is joint ownership with right of survivorship. In many states, this form of ownership is referred to as joint tenancy with right of survivorship or simply joint tenancy. Some states also have other forms of ownership that convey a right of survivorship. For example, tenancy by the entirety and community property with right of survivorship are two forms of ownership available to married couples in certain states. The "right of survivorship" created by these types of ownership means that if one co-owner passes away, the surviving owner takes full ownership of the asset without need for the probate court's approval. This type of ownership can be contrasted with tenancy in common, which generally implies that each owner owns a discrete share of the property, without any right of survivorship. With a tenancy in common ownership, a co-owner who passes away is permitted to name a beneficiary for his or her share in an estate plan.
Tyler and Julie are a married couple who have lived in California throughout their lives. They bought their home many years ago and took title as "Tyler Jones and Julie Jones as community property with right of survivorship." Upon Julie's passing, the family's estate attorney prepares a new deed reflecting Tyler's 100% ownership, presents the death certificate to the county recording office and files the new deed. Because of the right of survivorship, probate court administration is not required to complete this change of ownership.
Many married couples hold title to their assets in a form that conveys a right of survivorship. However, some assets, such as IRAs, must be held in a single individual's name and cannot be jointly-owned. Thus, while ownership with right of survivorship is a common and convenient probate avoidance tool, it is often only one aspect of an estate plan. There are two other non-probate transfer mechanisms that may be utilized for certain assets.
A trust is an agreement between a grantor who contributes property to a trust and a trustee who administers the property on behalf of one or more beneficiaries. The trustee administers the trust property according to the instructions in the trust document created by the grantor. The trustee's responsibilities may include investing the trust assets and making distributions to beneficiaries as provided in the trust document.
Many individuals set up a revocable living trust during their lifetime to outline how they would like their assets maintained during a period of incapacity or administered after their death. This process of setting up a trust is usually facilitated by an attorney. The creation of a trust requires drafting a trust document and often includes the transfer of asset ownership from the name of the grantor to the name of the trustee of the trust.
Sally's attorney drafts a revocable living trust and explains the need to transfer certain assets to the ownership of the trust. After signing the trust document, Sally contacts the custodian of her brokerage account to arrange for the change in ownership. She is asked to sign a form on the custodian's letterhead to authorize the change of the account owner from "Sally Duncan" to "Sally Duncan, as trustee of the Sally Duncan Revocable Trust."
After Sally's passing, the successor trustee is authorized by the trust document to assume possession of the brokerage account and distribute the proceeds among Sally's nieces and nephews. The successor trustee is permitted to carry out these arrangements without approval of the probate court.
Although many assets such as brokerage accounts, real estate and business entities can be transferred into a trust, retirement accounts must be held in the account owner's name. As such, an account owner is barred from transferring his or her retirement account into a trust during his or her lifetime. Fortunately, retirement accounts have beneficiary designations that allow for the bypass of probate in lieu of joint ownership or trust ownership.
Beneficiary designations are perhaps best known in relation to financial accounts, although they can exist under other names for a variety of assets such as real estate and vehicles. Checking, savings, retirement and brokerage accounts and life insurance policies all typically have beneficiary designation forms. These forms are provided by the account custodian to the account owner in paper or electronic form. The form will allow the owner to choose primary, and sometimes secondary or tertiary beneficiaries. The account owner may decide that the beneficiaries receive equal shares or select different percentages for each beneficiary.
Some financial accounts may be designated as transfer-on-death (TOD) or pay-on-death (POD) accounts, sometimes also called "Totten trusts." This type of designation is functionally equivalent to having a beneficiary designation, in that it allows for one or more named beneficiaries to receive an asset without probate court administration after the owner's passing.
Some beneficiary forms will also allow the account owner to specify what happens to a particular beneficiary's share if the beneficiary has predeceased the account owner. These options may include distributing the predeceased beneficiary's share to his or her then-living heirs (per stirpes) or dividing it proportionally among the other named beneficiaries (per capita). The form will remain on file with the custodian while the account is active, until the owner's passing. While the account owner is living, beneficiary designations can usually be changed at any time.
Terry worked in the software industry for many decades. Upon his retirement he sought the assistance of his financial advisor to roll over his sizable employer-sponsored 401(k) plan to an IRA with a new custodian. Once the rollover was completed, Terry's financial advisor presented him with a beneficiary designation form to complete and sign. Terry filled in the document as follows:
BENEFICIARY DESIGNATION FORM
Account Owner: TERRY THOMPSON
Account #: xx-xxxxxx
100% to KASEY THOMPSON (wife)
40% to CARL THOMPSON (son), per stirpes
40% to ANDREW THOMPSON (son), per stirpes
20% to SMALLTOWN ANIMAL SHELTER
The form also included the beneficiaries' contact information. At the time of Terry's passing, Kasey had predeceased him and Terry had failed to update his beneficiary form. Carl had also passed away five years prior in an accident.
Due to the per stirpes designation on Terry's beneficiary form, Carl's two living children, Caitlin and Meghan, were entitled to split Carl's 40% share equally between them. After receiving notification of Terry's death and confirmation that Kasey and Carl had predeceased Terry, the custodian transferred 40% of the IRA to Andrew, 20% each to Caitlin and Meghan and 20% to the Smalltown Animal Shelter, a qualified nonprofit. It was not necessary for the probate court to approve this distribution because of the beneficiary designation form on file for the IRA.
A properly executed beneficiary designation will facilitate the non-probate transfer of the asset on the owner's passing. This feature means the asset can potentially be transferred to the beneficiary directly, without being subject to the probate court administration process. Minimizing the need for probate administration may save time, costs and complication for the decedent's estate and its beneficiaries, such as family, friends and nonprofits. Setting up a beneficiary designation for an IRA or other qualified retirement account does not incur any cost or require an attorney's assistance.
IRAs and retirement accounts are assets that can very easily be excluded from the probate process. However, IRAs and other retirement accounts will sometimes become subject to probate proceedings. The probate administration of a retirement account typically happens if the account owner did not have a beneficiary designation form set up, the beneficiaries named are unavailable or the decedent's estate was named as the designated beneficiary.
Sydney worked for many years as a psychology professor at the local university. As part of her compensation package, her employer contributed a portion of her paycheck into a 403(b) retirement account for her benefit. Upon her departure from the university, Sydney rolled over the 403(b) account into an IRA. Since the balance was relatively small compared to her other investment accounts and real estate holdings, Sydney monitored the balance but did not think much more of it. Since her other assets and the bulk of her wealth were owned jointly with her husband, Gerald, she felt confident that if something happened to her, Gerald would have unfettered access to the family finances.
Earlier this year, Sydney passed away at age 68. Gerald sought the assistance of an estate planning attorney to help settle her estate. Gerald recalled Sydney mentioning the IRA and was able to locate a recent statement from the account. The attorney contacted the IRA custodian and was informed that no beneficiary designation had been set up. The attorney informed Gerald that in the absence of a beneficiary designation, the IRA would need to be transferred through the probate court process. Until the probate court gave its approval, the funds in the account would not be accessible to anyone.
Setting up an appropriate beneficiary designation for a retirement account can facilitate its transfer and create a more favorable distribution schedule for the remainder beneficiary. If a spouse is named as the beneficiary of a retirement account, the spouse will typically have the option to roll over the account to themselves. This inherited IRA rollover option enables the spouse to take required minimum distributions from the account over his or her own life expectancy. For a recipient of a traditional retirement account, this life expectancy distribution schedule will permit the beneficiary to pay the associated income taxes over an extended number of years. A non-spouse beneficiary who is named on a retirement account beneficiary designation is generally subject to a ten-year distribution period.
On the other hand, if a retirement account is payable to a beneficiary's estate, either directly or due to the lack of a beneficiary form, the entire account may need to be disbursed within a shortened five-year period. This five-year distribution period can apply even if the remainder beneficiaries are close family members such as a spouse or descendants. The shorter the distribution period, the sooner the income taxes will need to be paid on any inherited traditional retirement assets.
The estate attorney hired to administer Sydney's estate called Gerald with an update. The attorney informed Gerald there was a date on the court calendar for the probate proceedings to begin. Gerald wanted to know if he would have to take Sydney's IRA as a lump sum once the probate proceedings concluded, or if he had a more favorable option to delay taking payments or stretch them out for a period of time.
The attorney explained to Gerald that in many cases, a surviving spouse can roll over an IRA inherited from a spouse and then take required minimum distributions based on the surviving spouse's life expectancy. However, for this to be possible, the surviving spouse must be named as the primary beneficiary of the account. Since the account was not designated directly to Gerald, but rather would have to pass through Sydney's estate, Gerald could not utilize the spousal rollover option. As a result, the IRA would need to be fully distributed within five years of her passing with the income taxes paid accordingly.
By using beneficiary designations for their retirement accounts, donors retain control over their assets during their lifetimes and enjoy flexibility in naming or adjusting their beneficiaries. When properly executed, beneficiary designations eliminate the need for the asset to be transferred through the probate court upon the account owner's passing. A properly completed beneficiary form can also ensure the recipient of a retirement account is entitled to the longest distribution period possible. Although beneficiary designations will not fully replace the need for a will or other estate planning documents, they are an important component of a well-rounded estate plan. Professional advisors are in a unique position to encourage their clients to be proactive about designating and updating their individual and charitable beneficiaries.