Don’t Make Bad Beneficiary Designations (Part 2 of 3)

Beneficiary designation is a very important part of establishing your estate. By failing to name a beneficiary of retirement accounts you are effectively appointing your estate as the beneficiary. Having your estate as the beneficiary of a retirement account could present many tax and non-tax problems for your family and heirs. In the second part of our series on making bad beneficiary designations we’re going to explore how this common mistake can ruin an otherwise prudent estate plan.

Mistake No. 2 – Failing to name a beneficiary of retirement accounts

The owner of a retirement account – such as an IRA, 401(k), 403(b), pension or annuity – may name a beneficiary of the account. Often the account is income-tax deferred, meaning that the owner of the account does not pay income tax on the earnings from the account until those earnings are actually received at some point in the future.

The account passes to the beneficiary named by the owner when the owner of a retirement account dies. The account passes to the owner’s estate if the beneficiary is not living or no beneficiary has been named by the owner.

When a retirement account passes to an individual as the named beneficiary of the account, the beneficiary is usually permitted to take distributions of the account over time (based on life expectancy) and delay triggering the income tax liability.

But when a retirement account passes to the deceased owner’s estate, the estate is required to cash in the entire account within five years of the owner’s death. The estate must receive all of the earnings from the account within the five years and must pay income tax on all of the earnings.

For those who are charitably minded, naming a charity as the beneficiary of a retirement account can be a great option. So long as the charity has tax-exempt status from the IRS, the charity can receive the entire account at the owner’s death, including the earnings, but will not be required to pay income tax on that property.

Solution: Consider naming an individual or charity as beneficiary of your retirement account rather than naming your estate.

Follow your curiosity to Mistake No. 3.

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