Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices

By Clifton Linton
Senior Writer, mPower

In This Story The Smith Saga Determining Life Expectancy Calculating Distributions Naming Beneficiaries

Choosing a withdrawal method and beneficiary for your IRA can be trickier than walking through a minefield blindfolded. After age 70½, your choices are permanent, and they can have a huge impact on the IRA's balance, taxation and the amount of flexibility your beneficiary has in dealing with the account.

Unfortunately, many errors are discovered after it's too late.

minute: read this article at a glance.

Adam Smith's father died in 1999, at age 74, leaving him and his brother an IRA valued at $1 million. But, Adam (a pseudonym) doubts he'll get to see much of that money.

Technical Terms Required minimum distribution (RMD) Beneficiary Life expectancy

The strategy his father, Paul, used to name his IRA beneficiaries and calculate his distributions requires Adam and his brother to withdraw the entire balance before the end of 2000. Facing such a large windfall, Adam might lose 35 percent or more of his share to income taxes this year. And understandably, he's unhappy about this.

Had Paul chosen a different IRA distribution method when he reached the required beginning date for making withdrawals from his IRA, Adam could have spread them out and paid a smaller tax bill.

The IRS requires all IRA holders to name a beneficiary (primary and contingent) and choose a method of distribution calculation by April 1 of the year after they turn 70½, if they haven't yet done so. That date is known as the required beginning date. That's also when you must start taking required minimum distributions from your IRA based on one of several IRS-approved formulas (discussed below).

But don't pick a distribution formula or your beneficiaries hastily. Essentially, the combination of beneficiary choice and distribution method is the variable in a distribution formula that can be changed as often as you like prior to age 70½. After that age, they're irrevocable. Indeed, if you have a situation like the Smiths' where his wife, Martha, died first, Paul can name a new beneficiary, but his distributions continue to be governed by the decisions he made at 70½.

"I've had $1 billion in mistakes come across my desk in the last 15 years," said Tom Gau, certified financial planner and principal with Oregon Pacific Financial Advisors in Ashland, Ore.

While appearing simple, in reality, the required beginning date elections can be very complicated, said Eric Donner, president and CEO of Metuchen, N.J.-based RDS, a maker of retirement distribution software. "It's very important that people understand the impact that these elections have on their total retirement wealth. The impact is difficult to ascertain on their own," he said.

For that reason, you should seek counsel from a financial planner or estate attorney who regularly deals with these issues and is very familiar with them, Gau said.

The Smith Saga

The Smith brothers' problems stem from a decision his father made a few years before reaching his IRA required beginning date.

Upon the advice of his attorney, Paul named Martha as his primary beneficiary. Also following the attorney's advice, the couple decided to stretch out the payments from the IRA by recalculating their required distributions every year. While it's common to name one's spouse as a primary beneficiary, the Smiths' difficulties stemmed from the fact that Paul decided to use a joint life expectancy and use the recalculation method for both life expectancies.

At age 70½, Paul began taking distributions from his IRA. But, then a year and a half later, tragedy struck. Martha died first.

"No one expected my mom to die first," Adam Smith said.

And that's when the problem materialized. The order of death is significant. For years, Paul had been in poor health and wasn't expected to live long. So, the family thought they had made the appropriate IRA beneficiary decisions. Besides, if Paul died first, as was expected, Martha, under the spousal rights provisions of the IRS' IRA rules, could roll Paul's IRA into a spousal IRA and restart the clock — making new beneficiary and distribution choices. But, Martha died first, and after the required beginning date. By that time, Paul's decisions were locked in.

Because Paul and Martha were both using the recalculation formula, when Paul died, the IRA had a zero life expectancy. As a result, the IRS required all money to be withdrawn from the IRA by the end of the year following the year of death.

Special Situations May Require Custodial Agreement Amendments If you have a special IRA distribution situation, such as wanting to leave money to a charity or multiple heirs, or wanting to preserve as much of it as possible for your grandchildren by using special estate trusts and beneficiary designations, your custodian may not want to comply with your wishes. The reason: Many standard IRA custodial agreements include default distribution language that may not be in the holder's best interests, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning. Here's one way to get them to do things your way. Get an attorney to help you draft an amendment spelling out your wishes and have that added to your IRA custodial agreement. If the custodian rejects the amendment, you can always find a new custodian.

Determining Life Expectancy

Figuring out the life expectancy you will use for your IRA distributions determines how long it will take you to exhaust the IRA.

The IRS allows IRA holders to calculate distributions using more than one life expectancy. You need to decide whether to use only your own life expectancy or use two, yours and that of one of your beneficiaries (you can only use two expectancies in total). Using more than one can help stretch out the withdrawals.

The IRS allows a single person at age 70½ a 16-year life expectancy. However, a married couple who both reach age 70½ the same year will have a joint life expectancy of 20.6 years, according to the IRS' actuarial tables. For more details about life expectancy calculations, see IRS Publication 590, Individual Retirement Arrangements.

The IRS has rules to prevent IRA holders from grossly extending withdrawals by naming a child or grandchild as primary beneficiary and using them to extend the life expectancy. For nonspouse beneficiaries who are more than 10 years younger than the IRA owner, the IRS will only let you add another 10 years on to the life expectancy you use to calculate your withdrawals. For example, if you try to name a 45-year-old child as a primary beneficiary, the IRS will only let you use a life expectancy of 26 years (your 16-year expectancy plus the extra 10 years).

Calculating Distributions

There are three methods for calculating IRA distributions: term certain, recalculation and hybrid. Each method has its pros and cons.

Term certain method: If you use this withdrawal computation method, you will withdraw all the money in your IRA by the time you reach 85. With this method, you start withdrawing 1/16th of your IRA account balance at age 70½. The next year you withdraw 1/15th of your balance, then the next, 1/14th, and so on. When you reach age 84, you will withdraw one-half of your IRA balance, and at age 85 you will withdraw the remaining balance.

A Possible Reprieve If a pending retirement bill is passed by Congress and signed by the President, retirees may have a one-year window of opportunity to fix any errors in their elections. The bill orders the Treasury Department to take one year to finalize the current rules governing IRA distributions. The rules, which the IRS has been using for the past 13 years, are only proposals. (Read our report on this legislation.)

This method may be preferable if you don't expect to live until age 85 and you hope to pass your IRA on to an heir. If you die at age 78, an heir may be able to use the remaining seven years of your life expectancy plus their own life expectancy for calculating withdrawals.

Recalculation method: The recalculation method is a good one to use if you worry about living past age 85 and running out of money. Each year when you take your withdrawal, you recalculate your life expectancy. The beauty of this system is that the IRS doesn't reduce your life expectancy by one year for each year you live, as the term certain method does.

Instead, the IRS has developed a formula that ends up reducing your life expectancy by less and less, the longer that you live. The IRS has published actuarial tables showing the life expectancies to use with recalculation. They don't run out unless you reach age 115.

The downside to using recalculation withdrawals is that "when you die, there is no more life to be recalculated. The IRA must be paid out," said Donner.

By choosing this distribution calculation method — as Paul Smith did — you "forfeit" the ability for an heir to stretch out an IRA.

Hybrid method: The hybrid approach is a combination of the previous two methods. In this case, the IRA holder may use recalculation for his life expectancy and combine it with a term certain life expectancy for the beneficiary (or vice-versa if the beneficiary is the spouse).

This is the strategy Paul Smith should have used, suggests Dennis De Stefano, certified financial planner with De Stefano Wealth Management of Maui, Hawaii. That way, Adam and his brother could have withdrawn the IRA balance over the remaining life expectancy of his mother, who died before 85.

Naming Beneficiaries

One of the most important choices you make when you fill out an IRA agreement is who you want to inherit your account after you die. Because IRA benefits are passed through beneficiary designation, similar to insurance proceeds, an IRA is not considered to be a part of an estate. Therefore, the choice you make on your IRA custodial agreement will supersede your will.

"I've had $1 billion in mistakes come across my desk in the last 15 years." — Tom Gau, certified financial planner and principal with Oregon Pacific Financial Advisors in Ashland, Ore.

Commonly, folks name their spouses as the primary beneficiary. You should also be aware that your spouse is by law your default primary beneficiary. If you do not wish your spouse to be your primary beneficiary, you must have him or her sign a form to opt out of this.

One of the most common mistakes IRA holders make is not naming a contingent (secondary) beneficiary or naming their estate as the contingent beneficiary. By default, if your primary beneficiary is dead when you die and you have not named a contingent, your IRA will automatically go to your estate, said John Wimbiscus, principal with Trinity Financial Advisors, L.L.C., of Chicago.

Related Reading How to Turn Your Retirement Money into an Income Stream What You Need to Know about Naming a Beneficiary

The problem with this strategy is that an estate has a zero life expectancy and all money must be withdrawn from the IRA if it becomes part of an estate. It won't be possible for the IRA balance to continue to grow through tax-deferred saving.

You should consult with an estate attorney or financial professional for the best strategy to use to pass money on to your heirs. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Avoid Expensive Mistakes When Making IRA Beneficiary, Distribution Choices

By Clifton Linton
Senior Writer, mPower

In This Story The Smith Saga Determining Life Expectancy Calculating Distributions Naming Beneficiaries

Choosing a withdrawal method and beneficiary for your IRA can be trickier than walking through a minefield blindfolded. After age 70½, your choices are permanent, and they can have a huge impact on the IRA's balance, taxation and the amount of flexibility your beneficiary has in dealing with the account.

Unfortunately, many errors are discovered after it's too late.

minute: read this article at a glance.

Adam Smith's father died in 1999, at age 74, leaving him and his brother an IRA valued at $1 million. But, Adam (a pseudonym) doubts he'll get to see much of that money.

Technical Terms Required minimum distribution (RMD) Beneficiary Life expectancy

The strategy his father, Paul, used to name his IRA beneficiaries and calculate his distributions requires Adam and his brother to withdraw the entire balance before the end of 2000. Facing such a large windfall, Adam might lose 35 percent or more of his share to income taxes this year. And understandably, he's unhappy about this.

Had Paul chosen a different IRA distribution method when he reached the required beginning date for making withdrawals from his IRA, Adam could have spread them out and paid a smaller tax bill.

The IRS requires all IRA holders to name a beneficiary (primary and contingent) and choose a method of distribution calculation by April 1 of the year after they turn 70½, if they haven't yet done so. That date is known as the required beginning date. That's also when you must start taking required minimum distributions from your IRA based on one of several IRS-approved formulas (discussed below).

But don't pick a distribution formula or your beneficiaries hastily. Essentially, the combination of beneficiary choice and distribution method is the variable in a distribution formula that can be changed as often as you like prior to age 70½. After that age, they're irrevocable. Indeed, if you have a situation like the Smiths' where his wife, Martha, died first, Paul can name a new beneficiary, but his distributions continue to be governed by the decisions he made at 70½.

"I've had $1 billion in mistakes come across my desk in the last 15 years," said Tom Gau, certified financial planner and principal with Oregon Pacific Financial Advisors in Ashland, Ore.

While appearing simple, in reality, the required beginning date elections can be very complicated, said Eric Donner, president and CEO of Metuchen, N.J.-based RDS, a maker of retirement distribution software. "It's very important that people understand the impact that these elections have on their total retirement wealth. The impact is difficult to ascertain on their own," he said.

For that reason, you should seek counsel from a financial planner or estate attorney who regularly deals with these issues and is very familiar with them, Gau said.

The Smith Saga

The Smith brothers' problems stem from a decision his father made a few years before reaching his IRA required beginning date.

Upon the advice of his attorney, Paul named Martha as his primary beneficiary. Also following the attorney's advice, the couple decided to stretch out the payments from the IRA by recalculating their required distributions every year. While it's common to name one's spouse as a primary beneficiary, the Smiths' difficulties stemmed from the fact that Paul decided to use a joint life expectancy and use the recalculation method for both life expectancies.

At age 70½, Paul began taking distributions from his IRA. But, then a year and a half later, tragedy struck. Martha died first.

"No one expected my mom to die first," Adam Smith said.

And that's when the problem materialized. The order of death is significant. For years, Paul had been in poor health and wasn't expected to live long. So, the family thought they had made the appropriate IRA beneficiary decisions. Besides, if Paul died first, as was expected, Martha, under the spousal rights provisions of the IRS' IRA rules, could roll Paul's IRA into a spousal IRA and restart the clock — making new beneficiary and distribution choices. But, Martha died first, and after the required beginning date. By that time, Paul's decisions were locked in.

Because Paul and Martha were both using the recalculation formula, when Paul died, the IRA had a zero life expectancy. As a result, the IRS required all money to be withdrawn from the IRA by the end of the year following the year of death.

Special Situations May Require Custodial Agreement Amendments If you have a special IRA distribution situation, such as wanting to leave money to a charity or multiple heirs, or wanting to preserve as much of it as possible for your grandchildren by using special estate trusts and beneficiary designations, your custodian may not want to comply with your wishes. The reason: Many standard IRA custodial agreements include default distribution language that may not be in the holder's best interests, said Victor Finmann, a Mineola, N.Y. attorney specializing in estate planning. Here's one way to get them to do things your way. Get an attorney to help you draft an amendment spelling out your wishes and have that added to your IRA custodial agreement. If the custodian rejects the amendment, you can always find a new custodian.

Determining Life Expectancy

Figuring out the life expectancy you will use for your IRA distributions determines how long it will take you to exhaust the IRA.

The IRS allows IRA holders to calculate distributions using more than one life expectancy. You need to decide whether to use only your own life expectancy or use two, yours and that of one of your beneficiaries (you can only use two expectancies in total). Using more than one can help stretch out the withdrawals.

The IRS allows a single person at age 70½ a 16-year life expectancy. However, a married couple who both reach age 70½ the same year will have a joint life expectancy of 20.6 years, according to the IRS' actuarial tables. For more details about life expectancy calculations, see IRS Publication 590, Individual Retirement Arrangements.

The IRS has rules to prevent IRA holders from grossly extending withdrawals by naming a child or grandchild as primary beneficiary and using them to extend the life expectancy. For nonspouse beneficiaries who are more than 10 years younger than the IRA owner, the IRS will only let you add another 10 years on to the life expectancy you use to calculate your withdrawals. For example, if you try to name a 45-year-old child as a primary beneficiary, the IRS will only let you use a life expectancy of 26 years (your 16-year expectancy plus the extra 10 years).

Calculating Distributions

There are three methods for calculating IRA distributions: term certain, recalculation and hybrid. Each method has its pros and cons.

Term certain method: If you use this withdrawal computation method, you will withdraw all the money in your IRA by the time you reach 85. With this method, you start withdrawing 1/16th of your IRA account balance at age 70½. The next year you withdraw 1/15th of your balance, then the next, 1/14th, and so on. When you reach age 84, you will withdraw one-half of your IRA balance, and at age 85 you will withdraw the remaining balance.

A Possible Reprieve If a pending retirement bill is passed by Congress and signed by the President, retirees may have a one-year window of opportunity to fix any errors in their elections. The bill orders the Treasury Department to take one year to finalize the current rules governing IRA distributions. The rules, which the IRS has been using for the past 13 years, are only proposals. (Read our report on this legislation.)

This method may be preferable if you don't expect to live until age 85 and you hope to pass your IRA on to an heir. If you die at age 78, an heir may be able to use the remaining seven years of your life expectancy plus their own life expectancy for calculating withdrawals.

Recalculation method: The recalculation method is a good one to use if you worry about living past age 85 and running out of money. Each year when you take your withdrawal, you recalculate your life expectancy. The beauty of this system is that the IRS doesn't reduce your life expectancy by one year for each year you live, as the term certain method does.

Instead, the IRS has developed a formula that ends up reducing your life expectancy by less and less, the longer that you live. The IRS has published actuarial tables showing the life expectancies to use with recalculation. They don't run out unless you reach age 115.

The downside to using recalculation withdrawals is that "when you die, there is no more life to be recalculated. The IRA must be paid out," said Donner.

By choosing this distribution calculation method — as Paul Smith did — you "forfeit" the ability for an heir to stretch out an IRA.

Hybrid method: The hybrid approach is a combination of the previous two methods. In this case, the IRA holder may use recalculation for his life expectancy and combine it with a term certain life expectancy for the beneficiary (or vice-versa if the beneficiary is the spouse).

This is the strategy Paul Smith should have used, suggests Dennis De Stefano, certified financial planner with De Stefano Wealth Management of Maui, Hawaii. That way, Adam and his brother could have withdrawn the IRA balance over the remaining life expectancy of his mother, who died before 85.

Naming Beneficiaries

One of the most important choices you make when you fill out an IRA agreement is who you want to inherit your account after you die. Because IRA benefits are passed through beneficiary designation, similar to insurance proceeds, an IRA is not considered to be a part of an estate. Therefore, the choice you make on your IRA custodial agreement will supersede your will.

"I've had $1 billion in mistakes come across my desk in the last 15 years." — Tom Gau, certified financial planner and principal with Oregon Pacific Financial Advisors in Ashland, Ore.

Commonly, folks name their spouses as the primary beneficiary. You should also be aware that your spouse is by law your default primary beneficiary. If you do not wish your spouse to be your primary beneficiary, you must have him or her sign a form to opt out of this.

One of the most common mistakes IRA holders make is not naming a contingent (secondary) beneficiary or naming their estate as the contingent beneficiary. By default, if your primary beneficiary is dead when you die and you have not named a contingent, your IRA will automatically go to your estate, said John Wimbiscus, principal with Trinity Financial Advisors, L.L.C., of Chicago.

Related Reading How to Turn Your Retirement Money into an Income Stream What You Need to Know about Naming a Beneficiary

The problem with this strategy is that an estate has a zero life expectancy and all money must be withdrawn from the IRA if it becomes part of an estate. It won't be possible for the IRA balance to continue to grow through tax-deferred saving.

You should consult with an estate attorney or financial professional for the best strategy to use to pass money on to your heirs. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.