We are receiving more calls about inherited IRAs from advisors than ever before. The first thing we ask is: Where’s the beneficiary form? … and then uh oh ... silence!
Checking the beneficiary form is one of the most valuable services you can provide. It enhances client relationships and leads to other, more in-depth planning conversations. Clients understand what you are doing for them and their family, and they are more likely to tell others about you. The beneficiary-form review is also your bridge to the next generation of clients. The bottom line is that reviewing them will increase your business. It’s also relatively easy.
Missing or incorrect beneficiary forms are still an epidemic and costly both in lost tax benefits and family harmony. It’s a mistake that generally cannot be fixed since it is most often discovered after the IRA owner or plan participant has died.
Beneficiaries are then forced to involve tax, legal and financial advisors to figure out how to distribute the funds when there are no clear instructions and more legal obstacles. That leads to long and expensive legal and family disputes that often don’t end well. The worst part is that these mistakes are so easy to avoid simply by checking beneficiary forms — while the client is still breathing!
As a financial advisor, the last thing you want is to have the next generation of clients wait for their money or be disinherited altogether due to negligence, even if it wasn’t your fault. You both lose.
My standard advice is for advisors to do a beneficiary form review whenever there is a big life event. That is, a birth, a death, a marriage, a divorce, a remarriage, a new grandchild, a change in the tax law or a change in any of the factors that were relied on in making the beneficiary selection in the first place. It could be that the client has changed her mind and wishes to eliminate or add a beneficiary. Advisors should have the kind of relationship with their clients that they would know when there have been major events in their clients’ lives.
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I feel like I’ve written this article over a hundred times (I’m sure I have), but the neglect in this area is rampant and the cases keeping coming. By cases, I mean court cases or IRS rulings where an advisor is on the hot seat or where family members are pitted against each other because this simple form was overlooked. Then everything becomes more expensive and the blame falls on anyone who had a fingerprint on the IRA, 401(k) or insurance policy involved. Advisors have often been roped into frightening litigation over beneficiary-form errors. I know because I get the desperate calls.
With IRAs and other retirement accounts, there are two areas that are most prone to beneficiary-form problems: divorce and IRA trusts. Both of these are usually big-ticket battles.
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Always check and update the beneficiary forms.
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This was a seven-year court battle because a life insurance beneficiary form wasn’t updated after a divorce. This is just the latest in the long line of cases where a beneficiary form was not updated after a divorce. This case could have also applied to an IRA or 401(k), as many others have.
For example, in the landmark U.S. Supreme Court case
IRA trusts: When a client names a trust as his IRA beneficiary it is generally because it’s a large IRA and the client wants to make sure it is not lost or squandered after death.
However, those benefits can easily be lost when the beneficiary form is either neglected or not in accordance with the client’s wishes.
For example,
There would have been a simple fix if the omission had been addressed while the IRA owner was still alive.
In another IRA trust case, two multimillion-dollar IRAs had to be paid out more quickly after death when the beneficiary form was not updated. Here, the financial advisor had everything set up correctly naming three trusts (one for each beneficiary) as the beneficiaries of the two IRAs. The advisor later changed custodians but the new custodian for some reason changed the beneficiary of each IRA to the estate. No one noticed or checked this detail until, of course, after death when the entire estate plan unraveled. The IRS said that the estate was the beneficiary at death and the estate is not a designated beneficiary, adding that a court cannot create a designated beneficiary.
The trustees paid $30,000 in IRS private letter ruling fees alone ($10,000 for each private letter ruling) in addition to legal fees and state court fees, and in the end, the case was lost anyway. The tax benefits lost here were in the millions, not to mention the damage to the advisor’s reputation.
All of this could have been avoided by ... guess what? Checking the beneficiary forms.
(Do I sound like a broken record yet?)
In other cases where an IRA owner created a trust to inherit the IRA, the trust was never named on the IRA beneficiary form. This is sometimes overlooked thinking that the trust takes care of naming the beneficiary. It does not. In order to get to the trust, the trust must still be named on the IRA beneficiary form.
Name contingent beneficiaries: To avoid beneficiary form problems, it is also important to have your clients name a contingent beneficiary in case the primary beneficiary predeceases the IRA owner or if the primary beneficiary wishes to disclaim his or her interest after death. The contingent beneficiary allows post-death flexibility to change a beneficiary if desired.
In addition to these oversights, other misunderstandings can also lead to errors with beneficiary forms.
The will does not replace the IRA beneficiary form: Clients often assume that the IRA beneficiary is covered in their will. We’ve seen this several times where a client names one of three children on the IRA beneficiary form (because that is the child that is taking care of all the paperwork) but his real intention is to have that IRA split evenly among his three children. He includes that equal split in his will, but after death, the IRA beneficiary form overrides his will and the entire IRA goes to the one child who is named. In one case, the daughter who was named on the IRA beneficiary form could have legally taken the entire IRA, but did not want to because she knew her father’s intent was to have the account split evenly. She ended up having to disclaim other assets to even things up. It was a bit messy and all avoidable if the IRA beneficiary form listed all of the intended beneficiaries correctly.
Loss of the stretch IRA: IRA beneficiaries can easily extend required minimum distributions out over their lifetimes with a stretch IRA. The IRA beneficiary must be an individual who is named on the IRA beneficiary form. That’s it. But the stretch is often lost when there is no IRA beneficiary named or the beneficiary form cannot be found. If the beneficiary is a child, grandchild or other person, the stretch IRA can be lost. That’s the case even if that same child inherits the IRA through the estate. The child does receive the IRA, but since the IRA was received through the estate, the stretch IRA is lost since the estate in not a designated beneficiary.
When there is no designated beneficiary, the post-death payout rules can accelerate RMDs and lead to higher taxes for beneficiaries.
All of these problems are getting worse as more people are inheriting IRAs.
In these ultracompetitive times, an annual beneficiary form review is a high-value service you can provide to your clients. Even the largest companies are not actively checking these essential documents.
Let clients know that you are on the case.
Advisor action plan
Advisors should take these steps to make sure all clients’ beneficiary forms are up to date:
- Take an inventory of all retirement accounts and locate beneficiary forms for each one. You never know what you might find, and it could lead to you bring in a new account from another advisor who was not as proactive and thorough.
- Follow up with a beneficiary form review after any major event in a client’s life (birth, death, marriage, divorce, etc.). In the absence of major events, address this issue at least annually.
- Make sure each beneficiary form not only names the beneficiaries desired by the client, but also names contingent beneficiaries.
- Make sure that the beneficiary is a designated beneficiary (an individual or qualifying trust). Not all beneficiaries are. Check that the estate is not named as the beneficiary.
- If a trust is the named beneficiary, ask if this is still accurate. Maybe things have changed. Check with the estate attorney, too. Also, make sure the trust is named on the beneficiary form.
- Finally, and perhaps most importantly, do you have a copy of the most current IRA or plan beneficiary form? Don’t count on the IRA custodian or the plan administrator for this important document. They may have nothing on file or an old version that lists incorrect beneficiaries, especially after a death or divorce.
- Make sure family members know where to locate all the beneficiary forms. You can help them by having copies on file.
