Everyone makes mistakes, including advisers. But there’s one blunder every planner should take extra precautions to avoid: being careless about ensuring that their clients’ IRA beneficiary forms are in proper order.

(Bloomberg News)
(Bloomberg News)

Failure to be vigilant in this area could ultimately cost the beneficiaries millions in tax-deferred benefits. Let’s look at one case as an example of how disastrous an error like this can be.

The story begins with an actual case about an IRA owner we’ll call Steve. Steve had two IRAs with the same custodian, and he worked with advisers employed by that custodian. As part of his estate plan, he named three trusts as his IRA beneficiaries. One trust was a 50% beneficiary, and two other trusts were each 25% beneficiaries.

The three trusts were drafted to meet look-through requirements. The intent was to allow distributions after Steve’s death to be paid to the trusts from the inherited IRAs over the life expectancy of the oldest beneficiary of each trust.

Ed Slott is the author of many books on IRAs.
Ed Slott is the author of many books on IRAs.

Steve’s advisers joined another firm and became affiliated with a different custodian. Steve met with his advisers and decided to transfer his IRAs to the new custodian. In error, his advisers gave Steve a new beneficiary designation form that named his estate as the sole beneficiary of a single new IRA.

SIGNING IT AWAY

Steve signed the form, and his IRAs were transferred to the new custodian. However, there was no evidence he intended to change his IRA beneficiary to his estate; all he intended was to transfer his IRAs to the new custodian. This error changed the beneficiary from the look-through trusts, which qualified as a designated beneficiary, to the estate, which is not a designated beneficiary.

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After Steve’s death, the error was discovered, and there was an attempt to fix it. First, the trustees went to court to modify the beneficiary designation for Steve’s IRA, so the trusts would be named instead of the estate.

Here they met with success. Based on its finding of Steve’s intent, the court ordered that the beneficiaries of the IRA were the three trusts, just as Steve had named them in his prior beneficiary designations. The order was retroactively effective to the date Steve erroneously signed the beneficiary designation form with the new custodian. So far, so good.

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The IRS denied the requests and said the inherited IRA must be paid out over Steve’s remaining life expectancy, because there was no designated beneficiary.

The next part of the plan did not go as smoothly. The beneficiaries requested three PLRs, one for each trust. In each PLR, they asked the IRS to follow the court order and allow distributions to be paid from the IRA to the three trusts over the life expectancy of the beneficiary of each of the trusts.

The IRS denied the requests and said the inherited IRA must be paid out over Steve’s remaining life expectancy, because there was no designated beneficiary. Steve's estate was named as the beneficiary at his death, and an estate cannot be a designated beneficiary because it is not a person and has no life expectancy.

TROUBLE FROM THE IRS

But what about the court order changing the beneficiary from Steve’s estate to his trusts? This did not fly with the IRS. As the IRS stated, “Although the court order changed the beneficiary of the IRA X under State law, the order cannot create a ‘designated beneficiary’ for purposes of section 401(a)(9).”

The IRS noted that courts have generally disregarded the retroactive effect of state court decrees for federal tax purposes. They said there are good reasons for this approach. Without it, claims would be filed in state courts for the sole purpose of trying to reduce federal taxes. Furthermore, federal tax liabilities could remain unsettled for years if state courts could retroactively affect the federal tax consequences of completed transactions.

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As the IRS stated, “Although the court order changed the beneficiary of the IRA X under State law, the order cannot create a ‘designated beneficiary’ for purposes of section 401(a)(9).”

Thus, the stretch over the life expectancies of the trust beneficiaries was lost, and the payouts to the trusts from the inherited IRA had to be based on the remaining life expectancy of the IRA owner, which was likely much shorter.

Steve was already over age 70 ½ at the time he named the trusts as beneficiaries. That creates a significant enough tax hit, but that is only part of the story. If the fee for each PLR was $10,000, that’s $30,000 plus professional fees, which for three PLRs might be another $20,000 or more. In addition, there were the court and attorney costs involved.

Those were the costs after death. In the planning phase, there were probably significant costs to creating the plan and the three separate trusts. This was not a quick “sign here” naming of a beneficiary for an IRA. There was substantial time, money, thought and planning put into this process.

AN UNINTENDED RESULT

But now, Steve’s carefully crafted estate plan was not carried out as intended. All of this was because the final step — checking the IRA beneficiary form after the transfer to the new custodian — was not done.

Due to the state court order, the IRA funds will pass to the three trusts as originally intended, but the post-death RMDs will be based on the rules that apply when there is no designated beneficiary.

Those rules depend on when an IRA owner dies. If he or she dies before the required beginning date, the entire inherited IRA must be paid out under the five-year rule, meaning the inherited IRA must be emptied by the end of the 5th year following the year of death. If death is on or after the RBD, then the inherited IRA funds are paid out over the deceased IRA owner’s remaining single life (had he lived).

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The child might be able to take RMDs for more than 30 years, while the grandchildren would be able to take RMDs for more than 50 years. Compare that with the payout period of 9.2 years.

That’s what happened in Steve’s case. So, for example, if he were age 80 at death, the IRA funds would have to be distributed over a 9.2-year remaining term. That’s the life expectancy factor, from the IRS single life table minus 1, for an 80-year old with distributions beginning in the year after death. That could be a much more costly distribution schedule compared to the one that was intended.

Let’s assume the three trusts were set up for Steve’s child and two grandchildren, who are in their 20s. The child might be able to take RMDs for more than 30 years, while the grandchildren would be able to take RMDs for more than 50 years. Compare that with the payout period of 9.2 years. Instead of the grandchildren being able to use their own life expectancies, they would effectively be considered the same age as their grandfather.

It is not uncommon for advisers to move to a different firm. When this happens, paperwork, such as the beneficiary form, is often lost in the shuffle. The disaster in Steve’s case could have been avoided if the beneficiary form was checked by either the adviser or the IRA owner, and corrected to name the three trusts, as intended.

The lesson here is to always follow up, particularly when IRA funds are being moved to a new custodian. The beneficiary forms must be checked to ensure they carry out the client’s wishes. Unfortunately, as evidenced with these PLRs, if a mistake on a beneficiary form is not caught before the IRA owner’s death, there may be no fix after the fact, even with a court order.

And that is truly a tragic ending.

Ed Slott

Ed Slott

Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer, IRA distribution expert, professional speaker and author of many books on IRAs.