Most individual retirement account owners want their loved ones to benefit from at least part of their IRAs. Many of them would be disappointed if they knew what actually happens to their IRAs and how easy it would have been to avoid the problems with simple, low-cost actions. Reviewing beneficiary designations is an important part of your financial plans. Do it for more than your IRAs. It also needs to be done for 401(k)s, employer benefits, annuities and life insurance.

Be on the lookout for these common mistakes.

No beneficiary. Naming a beneficiary is easy, and not naming one creates problems and often increases taxes and costs. Without a beneficiary, your IRA beneficiary is your estate. This converts an asset that avoided the delay and cost of probate (your IRA) into one that’s part of probate. It also takes away the opportunity for heirs to stretch out the IRA by limiting distributions. When the estate is the beneficiary, the IRA must be distributed within five years. Name someone as beneficiary. You always can change it later at no cost.

Vague beneficiary designations. Some people name as their beneficiaries “my children” or “my spouse.” That seems to make their intent clear, but problems can ensue. Stepchildren, for example, might be excluded under your State’s law. Or suppose one child passes away. Does his estate get his share, or do only children alive at the time inherit? When the “spouse” designation is used, divorce or death before you rewrite the will creates similar problems. The more your family situation differs from the stereotypical traditional family, the more important this is.

It’s a good idea to name specific people as your beneficiaries. It’s also a good idea to have an estate planner review your beneficiary designations. A good planner will ensure all the bases are covered and there aren’t any gaps or uncertainties in your designations.

Unprepared beneficiaries. An IRA beneficiary generally has unlimited access to the account. There’s nothing to stop him or her from withdrawing all the money, paying the taxes and spending the rest right away — or spending it all and forgetting that there will be taxes due. A beneficiary also could waste the IRA in unwise or fraudulent investments.

When you want the money to last for a while or you’re concerned about the beneficiary’s ability to manage the IRA, consider naming a trust as beneficiary. Your children or other loved ones can be beneficiaries of the trust. The trustee invests the money and controls the distributions, consistent with the tax law and what you wrote in the trust agreement. There are tricks to naming a trust as an IRA beneficiary, and I discussed them in past issues of Retirement Watch. You’ll need an estate planner to be sure it’s done right.

Outdated beneficiary designations. You can’t make a beneficiary choice once and let it ride. Things change. There are marriages, divorces, deaths, births and estrangements. One child might do very well financially while the other struggles or does less well. Do you still want them to share the IRA equally?

There’s also a nuance in second marriages that many people overlook. A current spouse can’t be disinherited from an IRA or other qualified retirement plan without assenting to it in writing. Suppose you were divorced or widowed and named your children as primary beneficiaries of your IRA. Then, you marry again. You even let your new spouse know that the children of your first marriage will be primary beneficiaries of your IRA. But the spouse can challenge that after you die and will be awarded the IRA if he or she didn’t sign the right form while you were alive. There are many other examples in court cases and rulings that show the importance of keeping beneficiary designations up to date, which I also discussed in past issues of Retirement Watch.

Failing to name contingent beneficiaries. A contingent beneficiary is someone who’ll inherit if the primary beneficiary died, disclaimed the inheritance or otherwise can’t inherit it. There are two reasons to have contingent beneficiaries for IRAs. One reason is that something could happen to your primary beneficiary, and then something could happen to you before you can change the designation form. When the primary beneficiary dies and there are no contingent beneficiaries, that’s the same as having no beneficiary, as we discussed earlier.

Another reason is contingent beneficiaries give your executor and heirs some flexibility and planning opportunities. The primary beneficiary, after being advised by your planner, could decide it is better for another loved one to inherit the IRA. Naming contingent beneficiaries allows the primary beneficiary to file a qualified disclaimer of the inheritance so that it passes to someone else. That’s not possible unless you named contingent beneficiaries.

Not retaining the forms. You shouldn’t depend solely on your IRA custodian. Custodians can lose forms or make other mistakes, especially when the firm is sold or merges. You need to keep copies of all your beneficiary designation forms and be sure your executor knows where to find them. Be sure to note which forms are superseded and which are the current versions. Or throw away the out-of-date versions.

Not considering charities as beneficiaries. When you plan to leave part of your estate to charity, carefully consider if the charitable donation should be of your IRA or other assets. When a non-charity is an IRA beneficiary, distributions are taxed as ordinary income to him or her just as they would have been to you. The non-charitable beneficiary really inherits only the after-tax value of the IRA.

But when a charity inherits an IRA, the distributions are tax-free to the charity. The charity receives the full value of the IRA. Your loved ones can inherit non-IRA assets, increase the tax basis to their current fair market value and sell them immediately without owing taxes. The appreciation during your lifetime is not taxed. Even inheriting cash is better for the loved ones than inheriting the IRA, because they’ll receive the full value of the cash. Carefully consider which assets you leave to charity.

– Bob Carlson