How to Use Custom Beneficiary Forms for Your Retirement Account

If you have an IRA, 401k, 403b, or other retirement account, chances are that you’ve completed a standard beneficiary form. Simply put, it designates who should receive the account upon your death. Most of these forms are very simple, and it works for most people. However, every once in a while you may need something more complex. In these scenarios, we would recommend completing a custom beneficiary form.

Benefits of a Custom Beneficiary Form vs. a Standard Beneficiary Form

In order to understand the benefits of a custom beneficiary form, it helps to understand the options that are available on the standard beneficiary forms that you will receive from financial institutions and their weak points. Most standard beneficiary forms allow you to name one or more primary beneficiaries and one or more contingent beneficiaries. There is often a box that you can check with respect to whether a person’s share should be distributed to a beneficiary’s descendants on a per stirpes basis if the beneficiary does not survive you. Everything must typically be done on a percentage basis.

The two major benefits to using a custom beneficiary form are that it can allow you to name beneficiaries using a dollar amount (vs a percentage) and it can better handle contingent beneficiary situations.

Understanding the Benefits of a Custom Beneficiary Form Using Examples

The best way to understand the benefits of a custom beneficiary form is by using a few examples.

Example 1.

Let’s assume that Joe wants to provide for his niece, Hannah, but once he is sure that she has enough, he wants any excess to go to charity (e.g. Autism NJ). Joe has a $1M IRA and he wants the first $600,000 to go to his niece and if there’s anything left over, he wants it to go to Autism NJ. If he used a traditional form, he would not be able to accomplish this particular goal. On a traditional beneficiary form, he would likely choose 60% to Hannah and 40% to charity. The problem with this is that if the IRA goes down, Hannah doesn’t receive enough. If the IRA goes up, she receives too much. If Joe were to use a custom beneficiary form, he can say precisely that $600,000 goes to Hannah and any excess goes to Autism NJ.

Example 2.

Let’s take the same example as above, except now Joe has one additional goal. Hannah has a minor child, Isaac. Hannah is divorced from Isaac’s father, Sigmund, and Sigmund has a gambling problem. Joe wants to make sure that if Hannah dies before him that Hannah’s share goes to Isaac, but he doesn’t want Sigmund to ever get his hands on the funds. If Joe uses the standard beneficiary form, he can check the box next to Hannah’s name that says “per stirpes”, so that Hannah’s share goes to Isaac if she dies before Joe. The problem is that Isaac is a minor, and a minor can’t easily inherit. A guardian would need to be appointed to handle those funds. That guardian would most likely be Sigmund as the father of Isaac. If Joe uses a custom beneficiary form, he can say that if Hannah dies before him that Isaac’s share gets sent to a trust for the benefit of Isaac and Joe can designate a trusted person to manage the funds until Isaac is old enough.

Example 3.

Let’s assume the same example as in #2 above, but now Joe has a revocable trust. Joe’s revocable trust says that upon his death the first $600,000 goes to Hannah, and that any excess goes to Autism NJ. The trust even clarifies that if Hannah dies before Joe, Hannah’s share would go to Isaac in trust. Joe can use a simple standard beneficiary form to name his revocable trust as the beneficiary, then the IRA will go precisely where he wants it to go. The problem with this is that it is not actually a tax effective way for Joe to pass on his wealth.* Again, this problem can be solved by creating a custom beneficiary form whereby Joe leaves the first $600,000 to his trust, and any overage directly to charity.

* There is an archaic tax rule known as the separate share rule. (Click on the link for an in-depth explanation of this rule, but essentially, after the owner of an IRA account passes, the beneficiaries must withdraw the IRA based upon various factors. Some beneficiaries can take out the IRA over their life expectancy, some must take it out over 10 years, and others must take it out within 5 years. If you leave your IRA to a trust, and there is an individual beneficiary (usually a 10 year withdrawal period) and a charity (5 year withdrawal period), the separate share rule dictates that everyone must use the shortest period for making the required minimum distributions. So, because the charity is a beneficiary, Hannah (or Isaac), must withdraw the IRA out over a 5 year period. By naming the charity directly in a custom beneficiary form, we avoid the separate share rule.

Example 4.

Let’s make a really complex example, because sometimes life can be complicated. Let’s assume that Joe is married to Riley. Joe has a $2M IRA and a $500K ROTH. Riley has a $1M 403(b). They also have another $3M of assets in a joint revocable trust. They do not have any children and they want to provide for a lot of relatives and many charities in the most tax efficient way possible.

If Joe dies before Riley, his specific goals with respect to his retirement accounts are:

1. $200,000 to Hannah, but if Hannah isn’t alive, her share goes to Isaac in trust
2. 70% of the rest to Riley
3. 20% of the rest to a Special Needs Trust for his sister, Betty. If Betty isn’t alive, this would go to Hannah.
4. 10% to Autism, NJ

If Riley dies before Joe, Riley’s specific goals are:

1. 50% to Joe
2. 10% to Adam (Brother), but if Adam isn’t alive, his share goes to Joe
3. 10% to Carly (Sister), but if Carly isn’t alive, her share goes to her children in trust
4. 10% to Dylan (friend), but if Dylan isn’t alive, to Puppies Behind Bars (Charity)
5. 20% to Puppies Behind Bars

Upon the death of both Joe and Riley, they agree that:

1. 60% should go to Hannah, Betty’s Special Needs Trust and Autism NJ (based upon the same % as above), and
2. 40% should go to Adam, Carly, Dylan, and Puppies Behind Bars (based upon the same % as above).

It is highly unlikely that a standard beneficiary form will accomplish all of this. If we simply put all of this language into a revocable trust, and use a standard form naming the trust as the beneficiary, the money will go where you want it to go, but it won’t be tax efficient. The reason to work with an estate planning attorney who has a master’s degree in taxation is that we can help to make it tax efficient.

As an example of a way that we could help to achieve the clients’ goals and make everything tax efficient:

1. Joe can create a custom beneficiary form for the ROTH so that the first $200K goes to Hannah (this way Hannah can receive the funds tax free), with the balance going to Riley. The custom beneficiary form can designate contingent beneficiaries for Hannah and Riley. (Generally, it is good planning to send ROTH funds to individuals and taxable retirement accounts to charity since charities won’t pay the tax on it.)
2. Joe can then create a Third Party-Supplemental Needs Trust for Betty.
3. Joe can then create a Custom Beneficiary Form to benefit Riley 70%, the special needs trust 20%, and Autism, NJ by 10%
4. Riley can also create a Custom Beneficiary for her 403(b) to designate beneficiaries for those assets.
5. To the extent that someone receives too much or too little from their share from the custom beneficiary forms, they can be made whole using formulas in the joint revocable living trust. To the extent that we need to set up any trusts for minors, that can also be done in the trust.

Summary

There are many other ways to solve the problems above, including through the use of Charitable Remainder Trusts, dividing the retirement accounts into multiple accounts, or converting the retirement accounts into other types of assets. However, what I hope is clear from this article is that sometimes a standard beneficiary form from a financial institution is not enough to solve a problem. Sometimes filtering assets through a trust is not enough. Using a custom beneficiary form in conjunction with other sophisticated estate planning tools is the only way to achieve certain goals.

Final Important Tips for Using a Custom Beneficiary Form

If you wish to prepare a Custom Beneficiary Form, it can usually be attached to the standard form provided by the financial institution. However, NEVER ASSUME THAT THEY WILL ACCEPT OR HONOR IT! It is best practice to follow up with the financial institution to ensure that they have accepted it and will agree to honor it. Usually, you will receive a notice that they received it… that is not the same as them agreeing to accept it. It is not binding unless the financial institution agrees to honor it. Accordingly, we strongly recommend working with professionals to ensure proper compliance.