Designating Beneficiaries: What You Need to Know

Even if you name someone in your will to inherit your tax-favored retirement accounts (IRA, 401(k) and the like), that person may never see a dime of your retirement account money. Why? Because if you turned in paperwork that designated someone else as the beneficiary of those accounts -- when you first opened them or at some later date -- the "operation of law" principle says the designated beneficiary gets the accounts after you die. It doesn’t matter if your will or living trust document says you wanted the money to go to someone else.

Say you designate your spouse as the beneficiary of your IRA. Years later, you get divorced and update your will to specify that your IRA money should go to your adult children. However if you failed to turn in the paperwork to change the beneficiary of your IRA and you die tomorrow, guess what? The IRA money will go to your ex-spouse by operation of law. The fact that your will specifies to the contrary makes no difference. Bottom line: Dropping the ball here is a really bad thing.

You should always check your retirement account beneficiary designations anytime you update your will. If those designations don’t reflect your current desires, change them accordingly. Fill out a new beneficiary designation form and turn it into the retirement plan administrator or IRA trustee.

Even if you think all your beneficiary designations are in order, you should still check them every year or two just to make sure. Why? Because, believe it or not, retirement plan administrators and IRA trustees can screw up. They can lose your beneficiary forms or confuse them with someone else’s forms. Their computer records can get mangled or deleted. So please take charge and review your beneficiary designations. If changes are necessary then follow up to make sure they are actually made.

Generally, you'll have few problems leaving your tax-advantaged retirement account money to several different beneficiaries--for example, to your surviving spouse and your adult children -- as long as you do things right. You can designate multiple beneficiaries in two ways.

First Way: Name multiple beneficiaries for each specific retirement account. For example, you could specify that 50% of each retirement account balance goes to your surviving spouse and 25% of each account balance goes to each of your two adult children.

Second Way: Alternatively, you could set up separate accounts for each beneficiary. For example, say you want 60% of your total IRA money to go to your surviving spouse and 20% to each of your two adult children. You could set up three separate IRAs with three separate beneficiaries. Then you can arrange tax-free IRA rollover transactions to get the proper amount of money into each separate account. However, setting up separate accounts is only possible with IRAs (including Roth IRAs, SEP accounts, and SIMPLE IRAs). You can’t do it with a 401(k) or a profit-sharing plan account. Of course, setting up multiple accounts must be done before you die.

When possible, I recommend the second way because your beneficiaries may have wildly different objectives. Your spouse may want to gradually withdraw inherited IRA money over a number of years to pay retirement living expenses. Meanwhile, one adult child may want to immediately use some of the inherited money to purchase a home and another adult child may want to preserve the inherited IRA’s tax advantages for as long as possible.

When each beneficiary is given a separate account, each is free to do whatever he or she wants without affecting the other beneficiaries. In contrast, when all your beneficiaries inherit percentage interests in the same IRA (or IRAs), one beneficiary cannot withdraw money without the others being given their percentage shares at the same time. This can mean unwanted tax bills for beneficiaries who would otherwise be content to leave their money in the account. Your beneficiaries may also have wildly different investment objectives for their inherited IRA money. Obviously, this can cause friction when each beneficiary’s share is effectively trapped in a single account. Last but not least, setting up separate accounts ensures more flexibility from a federal income tax standpoint under the required minimum distribution rules that apply to inherited IRAs. Just be sure to check your state law, too. Your state may require that you obtain your spouse’s permission before you can designate anyone else as a primary account beneficiary.

It’s very important to turn in your retirement account beneficiary designation paperwork, and then monitor the situation to make sure what you want to happen actually happens. If your beneficiary designations are screwed up, you can’t rely on your will or living trust document to set things right. Finally, be aware that retirement accounts are not the only things affected by the designated beneficiary operation-of-law principle. It generally applies to death benefits under life insurance policies too, and, depending on the laws of your state, it may also apply to brokerage firm investment accounts.