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Suggestions on How To Deal with and Name IRA & 401k Beneficiaries

There is probably no more difficult part of IRA and 401k administration than dealing with beneficiaries. This applies to both the IRA Custodian/Trustee as well as the IRA/401k Owner. Not only are the IRS rules, regulations and procedures complicated and confusing, many states add their own layer of complications. So the first thing the IRA/401k owner should do is review their situation with their own legal counsel.

After that, the next thing to do is review the IRA and/or 401 Plan Agreement. And that means read all of it. Each plan agreement can have its own specific defaults in the plan agreement language. And each IRA and/or 401k plan agreement can be very different, so be sure read them thoroughly and completely.

Now the Beneficiary Election Form needs to be completed. We recommend never leaving any part of the document blank. If left blank, the document defaults will kick in, which may not be the way you wanted the plan assets to be distributed.

Again be sure to read the language in the document. Some beneficiary election forms allow you to pick a type of distribution calculation. Others do not.  What does that mean?

Different documents call the methods by different names but one common description is allowing the beneficiary calculation to be done on a Pro Rata Basis, or by a Per Stirpes Basis.

Rather than giving you the legal description, we will give an example of each calculation method, which we think better describes the two methods. NOTE: This applies to both IRAs and 401ks, and to naming both Primary Beneficiaries and Contingent Beneficiaries.

In most cases IRA Owners name their spouses as Primary Beneficiaries and the Children as Contingent Beneficiaries. In many cases, when the first spouse passes, beneficiary election forms are not changed, or not changed right away. So the children become the Primary Beneficiaries of record.

 RATA (PER CAPITA) METHOD

First, this is the most common, and in many documents is the ONLY option allowed. READ YOUR DOCUMENT CAREFULLY!

Example #1: The IRA Owner named the three children under the Pro Rata Method, each sharing equally. If the three children survive the IRA Owner, their surviving parent, each child obviously receives one-third of the IRA assets. Understandable and no problem here.

However, what if Child #1 predeceases the IRA Owner? Nothing is changed on the beneficiary election form, which is usually the case, so when the IRA Owner dies, there are two remaining, surviving children. Under the terms of Pro Rata the two surviving children each receive ONE-HALF of the IRA assets. Nothing is allotted to the deceased child or his/her estate/family. The two surviving children share the entire IRA per the terms of the Pro Rata Method.

We can not tell you how many consulting calls we get about this situation, because the surviving children usually feel that they were only intended to receive a one-third share. (We’ll discuss a possible solution in another article.)

PER STIRPES (PER BRANCH) METHOD

Now let’s see what a difference this method makes.

Example #2: Same situation as above. If the children are all living upon the death of the surviving spouse/parent, each child again receives a one-third portion of the IRA assets. No change here.

However, if, as above, Child #1 predeceases the IRA Owner and again nothing is changed on the beneficiary election form, there is a big difference. The Per Stirpes Method allows the one-third portion previously allotted to Child #1 to be given to Child #1’s heirs and issues. The two surviving children, of course, still receive their one-third share.

Conclusion: As you can see, the difference is great between the two methods. And without additional legal expense, there is really nothing that can be done once the IRA Owner dies to change Example #1. (Again, we will illustrate a possible solution in another article.) The IRA/401k Owner must be careful because some plan documents do not allow any other method than pro rata. In some cases, the document can be amended to allow per stripes, but in some cases it can not be amended.

And again, the most important thing to remember is to seek your own legal counsel BEFORE completing beneficiary election forms.

Terry White

About Terry White

I started my business career after getting my degree in Accounting from the University of New Mexico in 1983. My first job was as a controller for a local title company, and in 1987 I started First Financial Escrow, Inc. Over the years I played a part in several startup companies including First Financial Equities, Inc., First Financial Trust, Inc., First Financial Marketing, Inc. and Asset Ventures, Inc. In 1997 First Financial Escrow, Inc. was able to purchase the escrow accounts from Sunwest Bank and changed its name to Sunwest Escrow. As the market changes, Sunwest has grown and changed along with it. Besides my wife, Sheila, we have three boys, two daughters-in-law, one grandson, another grandson on the way and a future daughter-in-law. Sunwest is my passion, and I enjoy coming to work every day to see what will happen next. I enjoy fly fishing, spending time in Colorado, biking and watching my boys play soccer.