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How to Prevent These Five IRA Transfer Mistakes

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Let’s discuss the five most common mistakes people make with their individual retirement accounts and how a professional advisor can help make sure these mistakes are avoided, or at least minimized.
 
They are not listed here in any particular order, so let’s start with No. 1.
 
1. Failure to make or update a beneficiary designation.
You would be surprised how often this happens. While some see it as complicated, it really isn’t. If the IRA owner does not designate a beneficiary or update a beneficiary designation, the survivors’ fate turns on default beneficiary language in the IRA contract. Moreover, failure to update a beneficiary designation — after a divorce, for example — leaves the default beneficiary language in place. 
 
This happens more frequently than people might realize. IRA contracts generally default to a surviving spouse, which can be a good outcome, except for blended families. If no spouse survives, the IRA contract may default to the estate, depending on the contract’s specific language. Unless the estate has large debts against it, an IRA’s defaulting to the estate is almost always a bad outcome.
 
Some IRA contracts now may contain language that revokes a standing beneficiary designation of a spouse upon the IRA owner’s divorce.  While this is not likely to undo community property rights, what an unpleasant surprise for the survivors (who could be your clients)! 
 
The beneficiary designation form is key to filing this crucial piece of information. When you make or update an IRA beneficiary designation, use the most current form approved for use by the custodian. Avoid using paper forms from the client’s file or records. Instead, go online and use the most current custodian’s portal to access a designation form. Verify that the date on the downloaded form is the most recent. If there is a question about that, call the home office and verify.
 
2. Failure to read the IRA contract.
This common mistake is the opposite of Mistake No 1. Help your clients ensure their wishes will be followed by reviewing the IRA contract with them.  This will ensure that they are not risking what may be their family’s largest single accumulation of wealth.  
 
I know that these contracts sometimes can run 10 pages or more, some with disclosures, enrollment information or prospectuses. However, you are looking primarily for certain items in those contracts. 
 
Look at the beneficiary designation and the custodial account or trust agreement. If you find something that creates a question, make that phone call to the custodian. Check the effect of divorce on the existing spousal beneficiary designation. Ask whether there is a “choice of law” provision. If the IRA is going to a minor or an incapacitated beneficiary, find out what effect those funds will have on that beneficiary. 
 
Be sure of the provisions related to the beneficiary’s responsibility for calculating and taking required minimum distributions (RMDs). Examine the procedures for splitting IRA accounts upon divorce or legal separation.
 
3. Naming a trust as beneficiary without understanding the potential consequences.
If your clients want to name a trust as their IRA beneficiary, you might consider two things. The first is whether the client’s estate planning goals would be met simply by using the IRA beneficiary designation, for example, and not by routing the asset through the trust. The second one is ensuring the designated trust is a “see-through” trust, in order to preserve the stretch option. 
 
It may also be important for the trust to be designed as a “conduit” trust that requires distribution of the RMD each year. In addition, if the trust is an “accumulation” trust, it could complicate the process of identifying trust beneficiaries. 
 
Naming a trust as beneficiary could fail the see-through test and destroy the stretch opportunity.
 
It’s important to note that a conduit trust design could directly conflict with estate planning goals such as sheltering IRA assets from the spouse’s estate for estate tax purposes or putting a barrier between the beneficiary and the IRA funds.
 
It is important to work with a good estate planning attorney throughout this process.
 
Before designating a trust, consider two options. Have the estate planning attorney provide input about using the IRA beneficiary designation to track what the trust would do with the assets.
 
Also, consider using a “trusteed IRA” — an IRA established with a trust agreement rather than a custodial account agreement. One benefit of this approach is that the IRA holder may be able to predesignate who will take the account upon the death of the primary beneficiary. This approach could be useful in cases where there are concerns about an individual beneficiary’s spending of the funds.
 
4. Naming an estate as beneficiary without understanding the potential consequences.
Many times an estate is named as an IRA beneficiary out of simple misunderstanding of what an “estate” is and how it is taxed. An estate can never be a designated beneficiary.  For IRAs not in pay status, the five-year rule will apply unless a spousal conversion is possible. 
 
If your client needs the IRA assets so debts will be paid after their death, then designating an estate may be a good idea. Check with the estate planning attorney for state-specific laws governing this.
 
A number of probating alternatives are available when an estate is designated an IRA beneficiary. One alternative is spousal conversion “through” the estate, which is the only way to preserve stretch-out. Another option is the application of the five-year rule, which is not changed when the IRA is assigned to a trust or other beneficiary. Your client may redesignate the IRA account as an inherited IRA in the name of the decedent for the benefit of the trust or other beneficiary. The five-year rule will not change. In cases of assignment or retitling, the IRA custodian’s assistance will be needed.
 
5. Not understanding the correct spousal election in relation to the beneficiary designation.
Many times the IRA beneficiary is a surviving spouse who is younger than the IRA holder. Surviving spouses can make a spousal election (spousal rollover) giving the IRA a fresh start on RMDs and beneficiary election. In essence, this spousal election “jump-starts” the IRA stretch. 
 
A spousal election could still be available when an IRA beneficiary designation names an estate or trust. Under a trust or will, the surviving spouse must have and exercise the right to demand payment of the IRA benefits to themselves. 
 
While there is no IRS rule on this point, in previous private letter rulings the IRS has interpreted Treasury Regulations regarding rollovers and RMDs to permit spousal elections “through” an estate or trust. You should verify this with your client’s estate planning attorney. In most cases, you will need a letter from the lawyer to the IRA custodian, reviewing the legal precedent for permitting spousal election through trust or estate.
Working with your client’s estate planning lawyer is best because they are usually the drafting lawyer or the one making the updates to ensure that the spouse is the sole trustee of the trust or executor of the estate, and that the spouse has the sole authority under the trust or will to pay the IRA proceeds to themselves.
 
I encourage you to work with an estate planning attorney to help prevent your clients from making these common IRA transfer mistakes. 
 

Lloyd Lofton is managing partner of 7 Figure Sales Tools, Marietta, Ga. Lloyd may be contacted at [email protected] [email protected].


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