Your most important estate-planning document is not your will…

Though a will is typically the document that gets the most attention when it comes to estate planning, it is not necessarily the most important one. If you have well-funded IRAs, it’s likely that the piece of paper that matters most to your heirs’ financial future is the form that designates which beneficiary or beneficiaries you want to inherit the IRAs.

Why? For one thing, it takes legal precedence over your will. And it could play a major role in determining how much your IRAs are worth to each of your heirs… how much they are required to withdraw each year under IRS required minimum distribution (RMD) rules… and how much money goes to the government in the form of taxes. Because federal income tax rates are expected to climb in the coming years, the beneficiary designation form will become even more important.

Unfortunately, most people don’t realize that improperly completed forms deprive heirs of thousands of dollars or more.

Here, common and costly traps…

TRAP 1: You name your estate rather than a person as the beneficiary. If you name a person as beneficiary, tax laws generally allow that person to “stretch” the required withdrawals over his/her projected lifetime — so the assets can continue to grow tax-deferred (or tax-exempt for a Roth IRA). This can mean decades of additional tax benefits.

Example: If you name your son beneficiary of your IRA and he is 40 when you die, he can stretch withdrawals out over his projected remaining life span of about 43 years. If there is $500,000 in your IRA at the time of your death… the account earns 6% annually… and your son takes full advantage of stretch rules, that $500,000 will turn into $2.4 million in total distributions before taxes.

If you name your estate as beneficiary, however, this stretch option disappears. Your heirs will have to withdraw the money from your IRA either by the end of the fifth year following your year of death… or if you have a traditional IRA and you die after age 70½, within a time period based on how much longer someone your age is expected to live.

What to do: Keep your IRA out of your estate by naming a real person or several real people as beneficiaries.

TRAP 2: You don’t inform your heirs where the beneficiary designation form is. If it can’t be located, your estate likely will be named the beneficiary, and the stretch option will be lost.

What to do: Keep one copy of the form in your own records and a second with your financial adviser or attorney. Inform your heirs where both copies can be found, and put a written explanation somewhere in your home of where these and other important documents are located. Review your designations annually, in case circumstances change, and remember to update all copies of the form if you make changes.

TRAP 3: You neglect to name contingent beneficiaries. Often, an IRA owner thinks that there’s no need to name a “contingent beneficiary” if he/she is certain that he wants the assets to pass to the primary beneficiary. But if the primary beneficiary dies before the IRA owner does and the owner neglects to update the form, the money reverts to the estate.

What to do: Always name a contingent beneficiary.

TRAP 4: You “mix” co-beneficiaries of different ages or types in one account. If you name multiple beneficiaries, every one of them will be required to take minimum distributions based on the expected life span of the oldest one. That’s not a major issue if your beneficiaries are of similar ages — but if there is a significant age difference, the younger ones could lose much of their ability to stretch out withdrawals.

Example: If you name your 40-year-old daughter and 75-year-old spouse as co-beneficiaries, your daughter will have to withdraw her share of the money within 13 years (based on your spouse’s expected life span) rather than slowly over your daughter’s expected remaining life span of about 43 years.

Naming your spouse and anyone else co-beneficiaries also could deprive your spouse of the right to do a rollover into the spouse’s own IRA, then treat the account as his/her own. Doing a rollover lets spouses delay making any withdrawals until they reach 70½ — but only if the spouse is the sole beneficiary of the deceased partner’s IRA.

If you name a nonperson, such as a charity or your estate, as a co-beneficiary, all beneficiaries will have to withdraw all of the money from the account either within five years following the year in which you die… or if you have a traditional IRA and die after age 70½, within a period based on tables that estimate how much longer someone your age is expected to live.

What to do: If you want to divide IRA assets between heirs of substantially different ages… between your spouse and anyone else… or between human heirs and other types of legal entities… divide your IRA into separate accounts prior to your death, then name a different beneficiary for each of those accounts.

If you don’t do this, after your death your beneficiaries could divide your IRA into separate accounts based on the portions that you specified for each of them and gain the same advantages — by law, they have until the end of the year following the year of your death to do this. But heirs often fail to understand the advantages of this or they just fail to get around to it, so it’s better to do it yourself.

TRAP 5: You select beneficiaries who will cash in the IRA quickly. An heir who has major debts or who tends to spend money as soon as he receives it is not an ideal IRA beneficiary, because he won’t gain the advantage of deferring taxes for years.

What to do: If you have more than one heir and have assets in tax-deferred retirement accounts and non-tax-deferred accounts, consider leaving the IRA to the heir who is likely to let the money continue to grow tax-deferred. Leave other assets to the beneficiary who is likely to tap the account quickly.

Also: If you have a Roth IRA as well as non-Roth savings, consider leaving the Roth to your heirs who are in the highest tax bracket, assuming that these high-bracket heirs are likely to take advantage of the stretch option. Money can be withdrawn from Roth accounts without triggering income taxes, which makes these assets especially valuable to heirs in high tax brackets.

Ask your financial planner or accountant to help you understand the amounts that your heirs will receive on an after-tax basis so that you can balance the gifts in a way that you consider fair.

TRAP 6: You neglect to inform beneficiaries that you already paid taxes on a portion of the IRA contributions. If you have made “nondeductible” contributions to your traditional IRA, your beneficiaries need not pay taxes on that portion of your savings when they withdraw it. Trouble is, many people don’t tell their heirs about their nondeductible contributions. Most heirs end up paying taxes that already have been paid.

What to do: Tell your beneficiaries verbally about any nondeductible contributions, and also attach written reminders to your beneficiary designation form and your estate plan. Attach a copy of your most recent IRS Form 8606 (Nondeductible IRAs) to the beneficiary designation as well.

TRAP 7: You fail to specify how the IRA should be divided. People tend to assume that if they list multiple beneficiaries, the money automatically will be divided equally among all those listed. This is not always the case.

What to do: If you want the money to be divided equally, you must write the word “equally” after the beneficiaries’ names or include a fraction or a percentage after each name. Otherwise it is up to the institution managing the account to infer your intent.