I bet you have no idea what would happen if your intended beneficiaries pass away other than in the order you assume.

This is an effective lead in to getting procrastinating potential clients to do a likely much needed review of their estate planning.

For many, including us, IRA and qualified plan interests may be the most significant financial asset.  This Tax Tip will use an IRA as the example, but the same issues generally apply for qualified plan interests.

On a typical IRA beneficiary form, there are primary beneficiaries and then contingent or alternate beneficiaries. Many participants having plan interests or owners of IRAs complete the forms either when the account or participation begins or complete or revise them online. The online form doesn’t usually accommodate trusts as beneficiaries. But even if the owner selects his or her children as contingent (or primary) beneficiaries, what happens if a child (who has children) predeceases the owner, and the owner doesn’t get around to confirming the need to change beneficiaries before the owner passes away? Does the IRA pass only to the survivors of the children, so the grandchildren of the deceased child take nothing? Or is it “per stirpes,” such that the deceased child’s children share the share of the child? Is this important if there are hundreds of thousands of dollars in play? Note that the Will or Living Trust do not override or effect IRA or plan beneficiary designations. Also note that some IRA custodian and plan administration forms default to a “survivors” of the beneficiaries rule, rather than “per stirpes.” This, of course, is easier for the IRA custodian to administer.

Another possible nightmare. Naming the owner revocable trust as the beneficiary might force the entire IRA to be distributed quickly, unless the trust has specific provisions.  Simply naming the family or living trust will not assure avoiding having to distribute the entire IRA or plan interest to be fully taxed over the next 5 years, instead of qualifying for a slow taxable payout over the expected life of the young beneficiary.

Example 1: Joe, unmarried, has a $1,000,000 traditional IRA. He names his two children (who both have their own children) as beneficiaries. One of the children dies, then Joe dies without changing his beneficiary designation. Under some custodians’ forms, the surviving child gets the entire $1 million.

Example 2: Joe, unmarried, again with the $1,000,000 traditional IRA, names his revocable living trust as the beneficiary. His trust names his two children as its beneficiaries. Whether the children survive him or not, those who receive the IRA interest likely will be required to pay tax on their entire IRA share allocated to them within 5 years, instead of, say, 40 years. (If Joe lived to his required beginning date to receive required minimum distributions (generally after he is 71), the children at be will be forced to pay tax on their share over at best 17 years.)

For more information on this week’s Halloween Tax Tip, please feel free to contact Les Raatz at x5022 (602-285-5022) or the other estate planners haunting the firm.