Q&A: Do we need contingent beneficiaries if we have wills?

with No Comments

We recently received the following question from a Do-It-Yourself client:

Do we need contingent beneficiaries if our wills specify how to distribute our assets in the event that we are both deceased?

The short answer is absolutely yes you do. Here’s why:

Inheriting a retirement account without messing up your required minimum distributions (RMDs) is surprisingly difficult. There are thousands of articles telling you things not to do, and even estate attorneys make mistakes.

First, you need to understand that when a spouse inherits retirement account assets, she (or he) has the right to do what is called a “Spousal Rollover” where she receives the decedent’s IRA as though it were her own. This effectively means that she does not have to do any inherited RMDs. Missing a spousal rollover is a very costly mistake. For this reason, we recommend that your spouse be your primary beneficiary on all retirement accounts, if that is in line with your estate wishes.

Second, you need to understand that other than a spouse, there is only one other group of heirs that gets special treatment when it comes to inherited RMDs. That group is designated beneficiaries. Designated beneficiaries are permitted to use an “inherited divisor” which permits distributions based roughly on their life expectancy. All other heirs are subject to a 5-year distribution schedule which leeches the tax benefits out of both traditional and Roth IRAs.

Imagine that an IRA doesn’t have any designated beneficiaries. In this scenario, the IRA goes to probate, as all assets without “will substitutes” do, and is divided according to the decedent’s will — to the children, let’s say. Problem is, those children were not designated beneficiaries so they don’t qualify for one of the two exceptions (a designated beneficiary or a spouse). Thus, they are subject to the 5-Year Distribution Rule. If probate passes the IRA to a spouse, well, he or she always has an exception to do a Spousal Rollover. If probate passes it to a trust, it doesn’t matter how the trust is set up, it was not designated as a beneficiary, so it uses the 5-Year Rule.

The solution to this horrible problem is to clearly designate beneficiaries.

People or trusts can qualify for the exception by being designated as beneficiaries. And, according to an IRS Private Letter Ruling, the heirs of your Will’s probate may be able to qualify to the exception if your estate was explicitly designated as a beneficiary.

Third, you need to understand that probate is a terrible process for your survivors.

Probate is the place your will is read. All your probated assets are subject to probate fees and taxes as well as distributed on public record to the beneficiaries in your will. Your executor is required to provide detailed accounting down to the tradelot for all the assets in probate. Then, adding insult to injury, they must pay a fee based on how many pages are in these accounting reports.

Being an executor is a difficult, mostly thankless job, often compounded by grief at the loss of a friend or loved one.

If you can make all your assets avoid probate, then you will be doing a great service to your beneficiaries.

Thus, for all these reasons, it is very important that you set all your beneficiary designations, including your contingent beneficiary designations.

Photo by Nathan Dumlao on Unsplash

Follow Megan Russell:

Chief Operating Officer

Megan Russell has worked with Marotta Wealth Management since 2005. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine