Check those beneficiary forms

The beneficiary form is the single most important estate-planning document of individual retirement accounts and Roth IRAs, determining the ultimate value of the accounts, who ends up with the money and for how long.

Every custodian has its own procedures for IRA conversions. Most times, a new account is established, and the completion of an updated beneficiary form is requested. In fact, it is more important to complete the beneficiary form for a Roth IRA than for a traditional IRA (though omitting the form in either case is never a good idea).

Absent favorable default provisions in the custodial agreement, an individual who inherits an IRA without being named (or being otherwise identifiable, such as “children equally”) on the beneficiary form won’t be considered a designated beneficiary. In such a case, if the IRA owner dies before the year in which he or she would have been required to take minimum distributions, the account must be emptied within five years.

If the IRA owner dies after his or her required beginning date, the distributions may continue to be stretched over the IRA owner’s remaining single life expectancy, had he or she lived.

But since a Roth IRA has no required distributions, its owner can never reach his or her required beginning date. This means that if there is no designated beneficiary, the account has to be emptied within five years after death.

This includes cases where the estate becomes the default beneficiary, which is common in many plan documents and IRA custodial agreements.

Of course, because an estate has no life expectancy, it should never be designated a beneficiary. Even though the same individual ultimately may inherit the account through the estate, that person won’t be considered a designated beneficiary of the IRA but rather of the estate.

Because assets in a Roth account grow tax-free, the longer the account compounds and grows, the better. That thinking is driving the IRA conversions of many wealthier and older clients today: the ability for their beneficiaries to stretch out tax-free distributions over their lives.

The older clients may not live long enough to make the conversion profitable, but by incorporating the next generation, Roth conversions become a great planning strategy and wealth transfer vehicle. All that planning is for naught, though, if there is no beneficiary form and the account must be withdrawn in five years after death.

Let’s take an example. Jane, 80, converts her $500,000 traditional IRA to a Roth IRA in 2010. Jane isn’t converting for her benefit, because at 80, it really doesn’t pay.

She is converting for estate- planning reasons, because she doesn’t need the money in her IRA, has plenty of other non-IRA funds from which to pay the tax and wants to name her 10-year-old grandson, Tom, as the IRA beneficiary so that he can stretch the Roth IRA over his lifetime, income-tax-free.

When Jane converts her traditional IRA to her new Roth IRA, however, she doesn’t name a beneficiary on the Roth IRA, thinking that either the name will automatically be the same as the beneficiary on her traditional IRA or that the financial institution will take care of it. But nothing automatic happens, and the default beneficiary on Jane’s custodial document for her new Roth IRA states that when no beneficiary is named, her estate is the beneficiary.

Even though Tom is named as the Roth IRA beneficiary in Jane’s will, the estate is actually the beneficiary. Tom will still inherit the Roth IRA from the estate, but the entire inherited Roth IRA account balance will have to be withdrawn by the end of the fifth year following the year of Jane’s death.

This will be an expensive mistake. Say Jane dies at 89; assuming an 8% compounding rate, the Roth IRA balance at Jane’s death is $999,502.

If Tom is able to stretch the inherited Roth IRA over the full 63-year term, he will be able to withdraw $27,105,366 income-tax-free. But since he is stuck with the five-year rule, he will have to withdraw all the inherited Roth funds, which will be worth only $1,468,597 at the end of the fifth year after death.

Tax-free compounding on that amount is no longer available to Tom, which means that Jane made a multimillion-dollar mistake.

Check that new beneficiary forms are in place for all new Roth accounts created.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com. For archived columns, go to InvestmentNews.com/iraalert.

For more archived columns, go to InvestmentNews.com/iraalert