Beneficiary Designations
 There are two things you
should never watch while they are being made: one is sausage and the other is tax law. The same can be said of most tax law changes. They often result in more complex
do’s and don’ts, not to mention stiff penalties for non-compliance.
That said, the IRS has simplified its regulations governing distributions from IRAs and other qualified retirement plans (QRPs) in recent years. In form, these final
regs are intended to liberalize and lengthen payout options during the lifetimes of plan participants and, after their deaths, for their designated beneficiaries. In substance,
however, there are many common pitfalls to avoid regarding the designation of beneficiaries for your QRP lest your retirement assets plunge into the tax abyss, or wind up with the wrong
beneficiary.
Disclaimer: This article is not an exhaustive treatise on this subject matter. Consider it a brief primer regarding the unique nature of QRPs and an advance warning to
avoid two common pitfalls regarding their post-mortem transfer.
Unique Assets
QRPs are unique assets. Their fundamental purpose is to help plan participants send some of today’s dollars ahead for tomorrow’s retirement. [Note: QRPs were
never intended as vehicles to build large estates for heirs.] To facilitate their fundamental purpose, QRPs enjoy preferential tax treatment during their creation and as they
accumulate. They are created with pre-tax dollars and then grow tax-deferred. Consequently, through the tax-deferred annual compounding of their interest and dividends, QRPs often grow to
produce rather impressive account balances. While they enjoy preferential tax treatment during their creation and accumulation stages, all distributions from QRPs are fully taxed as
ordinary income (except when made to a charitable beneficiary).
Here is where plan participants and the IRS have competing goals. Plan participants want to delay distributions from their QRPs and enjoy the tax-deferred compounding as long
as possible. The IRS, on the other hand, requires plan participants to take Required Minimum Distributions (RMDs) and to begin paying taxes on their distributions at ordinary income
rates no later than April 1st of the year after which they turn age 70˝ (and each year thereafter).
Upon the death of a plan participant, the final regs determine how quickly the remaining QRP must be paid out and taxed to the designated beneficiary(ies) based on a complex
variety of factors. Here are two common pitfalls to avoid.
Failure to Designate
The failure to designate a beneficiary is the most common mistake people make regarding their QRPs.
Consequences: 1) If you die after you begin taking RMDs, then the balance of your QRP must be paid over your remaining life expectancy, using your account
balance at the end of each year, your age at death (+ 1 thereafter) and the applicable divisor found in the Single Life Table (SLT) in IRS Publication 590; or 2) Even worse, if you
die before you begin taking RMDs, then the balance of your QRP must be paid out within five years of your death.
Solution: Designate a loved one as the beneficiary. This will allow your QRP to be withdrawn in a more favorable manner than if you failed to designate a beneficiary at all.
This simple move can save thousands of dollars in taxes.
Failure to Re-Designate
If you are divorced, and fail to re-designate a new beneficiary, your ex-spouse could inherit your QRP if it is provided by your employer under the Employee
Retirement Income Security Act of 1974 (ERISA).
Consequence: If your QRP is governed by ERISA, and you fail to replace an ex-spouse, as beneficiary, they may inherit your QRP, even if your state’s laws automatically
extinguish their interest in your estate. [See the United States Supreme Court decision in Egelhoff v. Egelhoff, 121 U.S. 1322 (2001) for the case facts and ruling.]
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