Passing On Your IRA

Now you can protect those accounts for your heirs

So you've just spent weeks on your estate plan, agonizing over how your heirs will be cared for and which cousins will get what slice of your property. Too bad none of that work will affect what could be your biggest asset--your retirement accounts.

It's a little-known fact that individual retirement accounts, 401(k)s, and other tax-deferred plans aren't governed by wills or state inheritance laws. Instead, the disposition of your retirement funds depends on two things: the fine print of your bank or fund company's custodial agreement and the tiny lines where you listed beneficiaries. Chances are you've never given either much thought--an oversight that risks frittering away a major asset on taxes, or sending it to an heir you never intended to enrich.

To head off those problems, planners increasingly advise clients to create "retirement asset wills" (RAWs)--documents spelling out beneficiary designations and distribution plans in detail. American Express Financial Advisors, for example, is introducing RAWs in hopes of capturing a larger share of the $231 billion annual market in rollover IRAs. Stuffed with a career's worth of 401(k) savings, such accounts now frequently contain $1 million or more.

But it's still tough to find an adviser who can steer you through an IRA estate plan. "Your typical estate lawyer hopes you'll spend your last IRA dollar, then drop dead, so he won't have to deal with the account," says Victor Finmann, director of tax and legal planning for Retirement Distribution Strategies, a Summit (N.J.) consulting firm.

A good IRA estate plan deals with three basic goals. First, you want to make sure your heirs don't have to raid the IRA to pay estate taxes. If they do, they could lose up to 78% of the account to estate and income taxes. Provide liquid assets or life insurance to cover estate taxes.

CONTROL. Your second goal is to minimize forced distributions of the IRA's proceeds. The IRS imposes minimum annual distributions starting the year after you turn 70 1/2 or upon your death. The amount that must be withdrawn and taxed is based on life expectancies--yours or your heirs'. The No. 1 mistake: naming your estate as a beneficiary. In most cases, an estate must clean out the account within five years. It's better to leave an IRA to younger beneficiaries and to split the account so each heir can use his or her own life span to calculate distributions. New rules proposed by the IRS allow heirs to split an account as late as two years after the owner's death--but you've got to provide instructions.

For many IRA owners, the main reason to draft a RAW has nothing to do with taxes and everything to do with control. The custodian's fine print may not let beneficiaries relocate the account to another money manager. It might allow a beneficiary to change heirs: If your daughter dies, your son-in-law's second family might get funds intended for your grandchildren. And custodians seldom address what happens if a beneficiary dies before you or at the same time. To resolve those questions, you need a detailed document.

Finding someone with the expertise to draw up a RAW is one challenge. Getting your bank or fund company to accept one is another. Many custodians don't want to deal with advice that may contradict their boilerplate--or don't know what to do if you replace two lines on their form with 10 pages of legalese. But custodians are realizing that "if they want the $1 million IRAs, they've got to provide this level of service," says Jere Doyle, manager of estate planning for Mellon Private Asset Management in Boston. So don't settle for a firm that won't honor your wishes. Your heirs deserve better.

By Mike McNamee

    Before it's here, it's on the Bloomberg Terminal.