It's an old story but a persistent one: the botched estate plan. Sometimes even lawyers screw them up. Chief Justice Warren Burger, who wrote his own will, reportedly omitted clauses that would have saved his family $450,000 in taxes. What's that old saw about the attorney who represents himself?
One reason errors are common, says Stephen J. Silverberg, president of the National Academy of Elder Law Attorneys, is that people assume any lawyer is qualified to write a will. Not so. "Estate planning is a legal specialty, just as cardiology is a medical specialty," he notes. Another reason is lawyers' failure to look beyond the documents they prepare. Wills don't govern accounts with beneficiary designations, such as 401(k) plans, life insurance policies and Individual Retirement Accounts. All too often, slip-ups involving IRAs cost heirs thousands of dollars in future earnings.
The will your bank wrote
The legal document that determines who inherits your IRA—often your biggest financial asset—is not your will but the beneficiary-designation form you get from the bank, brokerage, or other custodian that holds your account. In addition to that form, you also must pay attention to the fine print in the IRA plan, which is written to protect the company, not you or your family. (Some custodians, for example, restrict your heirs' freedom to move your IRA to another company.) Unfortunately, nobody may read these documents until it's too late. "I'd say 90 percent of lawyers don't ask to see the client's IRA forms," says Silverberg.
Worse, you may not even have a copy. Many people assume the custodian keeps the papers on file. Don't assume! Silverberg recalls one case in which a brokerage located a missing document in a box under the office coffee machine. And the financial crisis has only worsened the problem, says Ed Slott, a tax accountant and IRA expert: "Banks and brokers go out of business, advisers are laid off, and forms are lost." (To get a new form, call the custodian or go online.)
The price of a missing form
Your survivors can still get your IRA without the beneficiary form—the default beneficiary is your estate—but they'll have to empty the account and pay taxes on it much faster. For example, let's say you leave a $400,000 IRA to your 40-year-old daughter. If she is named as the beneficiary on the IRA form, she can stretch annual withdrawals from the account over her life expectancy, in this case, another 43.6 years. (Her first required minimum distribution would be $9,174—$400,000 divided by 43.6.) Her withdrawals are taxable, but the IRA balance keeps growing untaxed. Assuming an 8 percent annual return and minimum withdrawals, the IRA would grow to almost $1.2 million by the time she's 65, and she'd already have received $671,000.
But if the beneficiary form is lost or misplaced, the result is quite different, because the beneficiary—your estate—has no life expectancy. In this situation, if you died before reaching age 70 1/2 the IRA must be emptied within five years; if you lived past 70 1/2 it must be emptied over your remaining life expectancy. (At age 75, for example, that would be 13.4 years.) Either way, your daughter loses decades of untaxed investment growth.
An incomplete or ambiguous IRA form can be even costlier. Slott remembers six siblings who inherited their mother's $600,000 IRA. Her beneficiary form listed their names—but not what share of the account each child was to receive. "The bank decided the first named child was the primary beneficiary, and the others just contingent beneficiaries," says Slott. "It paid the entire IRA to the oldest child. To divide it with her siblings, she had to withdraw the money, paying more than $240,000 in taxes that could have been avoided if the mother had just put two words on the form: 'equal shares.'"
