I want to talk for a moment about Beneficiaries. How you designate your assets may or may not seem important to you, but it will be extremely important to those you leave behind. This is called Estate Planning, and it’s jokingly referred to as the way you can continue to control your money beyond the grave.
Naming beneficiaries on each of your financial vehicles is one of the most important things you can do. It will make the difference between total chaos, headaches, and possible unintended disaster – or a smooth, orderly, relatively easy transition for your loved ones after you are gone. It’s more than a nice thing to do; it is essential. Just talk to anyone who has had to serve as an Executor for a loved one’s estate.
I’m going to focus on IRA assets here. Naming beneficiaries on these accounts may seem pretty straightforward, but it is often misunderstood. For example, did you know that the laws were recently updated and completely overhauled? The SECURE Act, which went into effect in 2020, was a monumental tax law change. (I wrote about it in this blog back in January 2020.) Unfortunately, it was completely overshadowed by other events that happened in 2020 (you may be able to name a few), so that many people (even advisors!) are still making financial decisions based on outdated information.
Don’t let that be you. Here are some of the highlights you need to know about naming beneficiaries.
First, there are now 2 different sets of rules regarding how inherited accounts are distributed. For deaths after 2020, the new SECURE Act rules apply. Deaths before 2020 were grandfathered under the old rules. If you have inherited money, you need to know which rule set you need to be playing by. In this article, I’m going to focus on the new rules. This is so you can think about how YOU want to leave money behind (rather than how you might inherit it), and the consequences for your beneficiaries.
Under the new SECURE Act rules, there are now 3 different types of beneficiaries. The rules for how a beneficiary inherits depend on what type of beneficiary they are. A colleague compared this to 3 different types of tickets at a concert: there’s the nosebleed seats, the regular seats, and the VIP section.
- In terms of beneficiaries, the “nosebleed seats” (least desirable) are “non-designated beneficiaries.” These are not people. For example, a charity, estate, or a non-qualifying trust.
How these entities receive the inherited money depends on whether or not you were taking your required minimum distributions yet (or were supposed to). Overall, these beneficiaries get the most restrictive rules. The only time you’ll hear about the “5-year rule” is for one of these beneficiaries.
For those under the “5-year rule,” the entire account balance must be withdrawn by the end of the 5th year. There are no annual requirements. So let’s say you leave $100,000 to “your estate.” That means your estate (whoever is managing it) has to take the money out – pay the taxes – and give all the cash to someone by the end of 5 years. They could do this all in the first year, or do it in small amounts for 5 years, or do nothing until the 5th year and then take all the cash out. This could be problematic for your heirs. We’ll explore why in a moment.
- One step “better” than the “nosebleed seats” are the regular seats, or the “non-eligible designated beneficiaries.” These could be grandchildren, for example, adult children, and some look-through trusts. For these lucky folks, there is the new “10-year rule.” It’s like the 5-year rule, except the entire account balance must be withdrawn by the end of the 10th year.
- Finally, let’s welcome the “VIPs” or “Eligible Designated Beneficiaries.” These folks have special provisions and some nice perks. Honestly, this is the type of beneficiary you want to name, if possible, so that your heirs get the most beneficial set of rules possible. The most important of these rules is the exemption from the 5 OR 10-year rule. In other words, for these special folks, there is no time clock! Once they inherit, they have the opportunity to keep the investments going for as long as they live. This is called the “stretch IRA.” This setup can potentially keep your beneficiaries in a more favorable tax situation, as well as give them a secondary gift: the opportunity of growth. In a stretch IRA, the investments can grow over their lifetime.
So, who are these lucky people? The SECURE Act created 5 classes of Eligible Designated Beneficiaries:
- Surviving spouse
- Minor children, up to the age of majority (18 or 21 in most states), OR, if still in school, age 26 – but NOT grandchildren, no matter what age
- Disabled individuals – as defined under strict IRS rules
- Chronically ill individuals
- Individuals not more than 10 years younger than the IRA owner (for example, siblings who are only a few years younger than you).
Here’s a significant detail about these 5 categories: they ONLY apply to DESIGNATED beneficiaries. In other words, beneficiaries only get these special VIP perks if they are named on the beneficiary form (not through your will). The beneficiary form supersedes all other estate planning documents. That is a commonly missed detail that can create unintended consequences.
If you don’t specifically name your beneficiaries, they cannot qualify for the stretch IRA “VIP perks,” no matter who they are, because they were not named. They fall into the first category, “non-designated beneficiaries,” up in the nosebleed seats. Let’s go back to the example of naming “your estate” as your beneficiary. You’ve just forced them to take all the money out in 5 years, and robbed them of a potentially significant growth opportunity.
A key takeaway from this should be: NAME your beneficiaries on the beneficiary form. Naming both primaries and contingents is best. Then, UPDATE them when life changes. If you don’t, you could be handing your loved ones seats in the “nosebleed” section when you thought you were giving them VIP tickets.
Next month I will discuss naming a Trust as your beneficiary, another interesting and often misunderstood topic. Stay tuned!