Americans own a greater share of their personal wealth in retirement plan accounts than ever before. For many people, their retirement account is their largest asset beside their home, and often retirement accounts are even more valuable than an individual’s home. This fact, combined with the advantages of tax-deferred growth and robust investment performance, means that, more often than not, individuals die leaving a significant balance remaining in their 401(k), IRA or other tax-deferred account.
As estate planners, it’s our job to advise clients on the most efficient way to pass these remaining assets to future generations while being mindful of clients dispositive wishes and concerns. However, the complexity of the IRS regulations governing these accounts mean accomplishing your goals often isn’t as simple as with savings or brokerage accounts.
1. The Married Couple
If you’re married, your spouse is living, and you plan on leaving everything to each other, it’s likely a good idea to name him or her as 100% primary beneficiary on your retirement account. Surviving spouses have special rights to “roll over” a deceased spouse’s retirement account into their own account. If the surviving spouse is under his or her retirement age, he or she will not have to take distributions immediately, and required minimum distributions will be calculated using the surviving spouse’s life expectancy.
2. The Responsible Beneficiary
If you’re single with children, or your spouse is deceased, you may wish to name your children individually as equal beneficiaries of your retirement accounts. In this circumstance, an inherited IRA would be set up for each child, and depending on your age at death, the child would have a number of options for taking distributions. Generally, the best option is for him or her to take distributions from the account over his or her life expectancy. This allows the assets to continue to grow, tax-deferred, while assets are withdrawn at the slowest possible rate. However, even if your beneficiary elects this option, he or she can still take more from the account if they need or want it. Often beneficiaries are financially secure, and able to manage the funds responsibly. However, for minor beneficiaries, beneficiaries who lack financial responsibility, or have substance abuse or other issues, the ability to withdraw lump sums from retirement accounts can present problems, especially when a larger withdrawal results in a larger income tax burden for the beneficiary. Additionally, for individuals who receive government benefits, the ability to withdraw large sums outright will generally result in disqualification for programs like Medicaid.
3. Some potential solutions
In these more difficult cases, it’s entirely possible to name a trust as the beneficiary of the retirement account (for IRAs). The Trustee will be able to control distributions to the beneficiary and, as long as the trust and beneficiary designation are correctly drafted, it should not result in disqualification for government benefits. Additionally, for beneficiaries who may be at risk of a significant lawsuit or bankruptcy filing, a trust can provide a level of creditor protection not available to individual owners of inherited IRAs. But there are a few technical issues that need to be clarified before you can safely change the beneficiary designation to name a trust. A retirement account’s best feature is the ability to provide tax-deferred growth. Assets grow tax free until they are withdrawn. Consequently, the aim of the game is to defer withdrawals as long as possible to maximize tax efficiency. However, to allow beneficiaries to “stretch” distributions over the longest period possible, an account must have a “designated beneficiary.” While individual persons automatically qualify as designated beneficiaries, only certain trusts can qualify, and the regulations to determine qualification are mind-numbingly complex. For example, a standard revocable trust can often contain provisions that would violate the IRS rules. If this kind of trust was named as a beneficiary of a retirement account, the account may have to be liquidated immediately, and the beneficiary may be hit with a significant tax burden in the first year following the account owner’s death.
How can you make sure your trust qualifies?
- Use of a Standalone Retirement Trust
Standalone retirement trusts (SRTs) are designed specifically to receive retirement account proceeds. They contain all the specific language required to pass the IRS tests, and don’t include language that would prevent the beneficiary from stretching distributions over his or her life expectancy. Additionally, where the account owner’s goal is to qualify the beneficiary for government benefits, or provide creditor protection, a separate trust is often the preferred vehicle for receiving retirement account assets.
- Use of a Trusteed IRA
Another option is to inquire whether your IRA vendor provides what’s known as a Trusteed IRA. This allows beneficiaries to stretch distributions, and provides independent trustee and management services. While this option may result in higher fees, tax efficiency is assured, as Trusteed IRAs are generally pre-approved by the IRS to qualify as designated beneficiaries. However, you are required to move your accounts to the Trusteed IRA during your life.
This is intended as a very brief overview of the issues and questions that should be addressed. Planning for retirement benefits can be complicated and complex. Appropriate time and resources should be allocated to this part of your planning. In addition, your beneficiary designations should be reviewed periodically and updated based on changes in the law, family, and or financial situation.