Designating IRA and other Qualified Plan Beneficiaries

Please note that this is a very complex area and what follows is generalizations.  This is an area that should be reviewed on a client-by-client, case-by-case basis with a qualified attorney or CPA.

The surge of Estate Planning “experts,” including websites and seminars over the past 20 years has created a surplus of “information” related to estate planning.  Much of this information, while useful in context, is misunderstood and consequently, misapplied.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

Along with the growth in family Estate Planning Trusts, has come a misunderstanding by many clients and advisors, of the inter-reaction between Trusts and Qualified Retirement Plans.  We tend to think of Trusts as the best solution for all of our Estate Planning clients’ needs.  In a perfect world, this might be true.  From a planner’s perspective, I would like nothing better than to have the flexibility to funnel all of a client’s assets through their Revocable Living Trust.  It would give us ultimate control.  Unfortunately, it doesn't work that way, and while a frustration for planners, it is what we have to work with.

There is no area more fraught with potential economic disaster that so-called, “qualified retirement plans” and IRA’s.  Unfortunately, because our laws are sometimes at odds with each other, there is potentially major income tax peril in linking qualified plans with a Revocable Trust.  While there will be times when the clients’ objectives will require us to do so, such linking is not without pitfalls, and should be undertaken only very carefully.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.

Qualified Plan and IRA Basics

The “idea” of qualified plans was to encourage people to do their own retirement savings.  The “carrot” was the ability to remove a portion of income from taxation when earned, and while it grew (in some cases, it worked “too well”).  Over my years as an Estate Planning Attorney, I have found it more common than not that a client has IRA and qualified plan assets that they are not drawing from, even when well into retirement.  However, the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation.

the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation

Because of this, the rules eventually require a “forced” withdrawal.  This normally ocurrs when the account holder (participant) reaches retirement age (“the year in which they reach age 70 1/2”).  A second instance is upon the death of the participant.  If the rules simply required a lump sum distribution at the death of the participant, it would be a simple mathematical equation and it would end there.  In that case there would be no issue with Revocable Trust beneficiary designation.  However, the law identifies some different methods of distribution and several of them are very tax-significant.

While an IRA is technically not a “qualified” retirement plan, it is by far the most common form of retirement savings, and shares essentially the attributes of a “qualified” plan.  Indeed once you are in “retirement mode,” the IRA is perhaps the better and more flexible retirement plan vehicle, particularly in terms of estate planning (and for this reason, we often counsel fully retired persons to roll their qualified plan assets into an IRA).  Most of the rules contained within IRS Regulations are specifically directed at IRA accounts.  IRAs are a more or less statutory retirement plan and as, such, are pretty typically similar, from sponsor to sponsor.  However, it is always advisable to read the plan document (be it an IRA or some other plan type), to ensure that it provides for what we think it does.  While we often apply IRA rules to other qualified plan accounts, it is important to understand that the plan documents may differ significantly.

When there is a Surviving Spouse

The Typical Family.

The most significant beneficiary designation involves the surviving spouse.  In the majority of planning situations, I deal with a married couple who have acquired assets together and raised their mutual children for a period of years.  Their typical wishes are to take care of each other in their retirement years and have any remaining assets go on to their children on a relatively equal basis upon their deaths.  In this case we almost never designate anyone but the spouse as the primary beneficiary of a participant’s retirement plan.  The spouse, in most circumstances, can elect to treat the decedent’s plan as their own.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.  While this is often a cause for angst, there are IRS rulings (in the case of an IRA) that would allow a surviving spouse who was the sole income beneficiary of the trust to remove the IRA and make the favorable spousal election.  It does, however, increase complexity and reduce flexibility.

“Unique” Circumstances.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets.  In this case, we may still want to designate a Trust as beneficiary.  For example, in a second marriage situation, the participant may wish to have the spouse have the annual income from the retirement plan, but ensure that any remaining plan assets go to their own children.  However, to use a common advertising disclaimer; "Do not try this at home."

While Congress has provided that it is permissible to designate a Trust as an IRA beneficiary (and, presumably, by analogy, other “qualified” plans); and the IRS has provided us with guidance on how to safely do so, that guidance is a proverbial minefield of danger.  Any misstep will likely not only result in a deemed lump-sum distribution (and therefore immediate income taxation) of the entire remaining balance, but will also very possibly result in taxation at the highest percentage brackets.

And, even if done properly, the appropriate administration of such accounts in a Trust guarantees long-term ongoing trust administration and lack of ultimate flexibility for the surviving spouse.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets

Contingent Beneficiaries and When there is no Surviving Spouse

The concerns are even more compelling when there is no surviving spouse, or when, because of a prior death, the contingent beneficiary designation becomes effective.  Only the spouse is entitled the “treat-the-account-as-is-it-were-my-own” (referred to as a spousal rollover) election.  However, an individual beneficiary may still have some ability to reduce the effects of taxation on the account.

An individually designated beneficiary may elect “beneficiary IRA” treatment (sometimes called a “stretchout” IRA by financial advisors).  The rules here are pretty clear when the beneficiary is an identifiable individual.  The beneficiary may use his or her life expectancy (in accordance with published IRS tables), to calculate an annual required minimum distribution.  Distributions must commence shortly after the death of the participant, regardless of the age of the beneficiary.  But obviously, there is significant value in the continued tax deferral of the balance of the plan assets during the lifetime of the beneficiary.

“pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

Unpredictable Beneficiaries

What if our intended beneficiaries are minor children, or children with special needs or other “disabilities?”  These are instances in which we might wish to use a Trust, even in light of all the pitfalls.  These might be one of the “compelling” reasons my “rule of thumb” acknowledges.

The IRS rules, as noted earlier, do allow for a Trust to be the designated beneficiary of an IRA.  But as also noted, not without complexity and inflexibility.  The Trustee may “step into the shoes” of the trust beneficiaries in only a couple of instances.  First, if all of the trust beneficiaries are identifiable persons and the trust provides for immediate distribution of all of their shares to them; or second, if the trust contains specific “pass-through” (sometimes called “see-through”) language.  If there is a class of beneficiaries (like “children” or “grandchildren”), the distribution rules will be keyed to the oldest person in the class (with the effect of forcing the taxable income out in the fastest manner).

In each case, the IRA custodian will likely be somewhat inflexible.  Typically, this means that a trust “beneficiary” IRA is set up and the Trustee is charged with calculating the annual minimum distribution amount, requesting it from the custodian, and distributing it to the beneficiary, in accordance with the trust language.  This will likely continue on a yearly basis for the lifetime of the youngest beneficiary or until assets have been exhausted.  While this gives the “stretchout” benefit, it must be balanced with the economic and emotional costs of maintaining the trust.

And, the “pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

What about Charitable Beneficiaries?

The IRS regulations are also clear about who may be a designated beneficiary for purposes of the “stretchout” election.  They must be identifiable individual beneficiaries.  So what if the trust (or the IRA by direct designation) provides for a charitable beneficiary?  The purpose behind the individual requirement appears to be so the life expectancy calculations may be accurately made.  Obviously, an entity cannot have a life expectancy.

But the IRS has acknowledged that charitable beneficiaries are common, and has given us a planning “out.”  As long as the charity’s portion can be determined and is paid out within a year after the death of the participant, the IRS will essentially ignore it.

What this does tell us is how important the details in planning are.  I often find it fits client’s objectives more closely to designate a specific portion of the IRA to charity, or event to split off a separate account and designate it entirely to charity.

As with all Estate Planning, we need to remember that it is a “moving target.”  Regular period review of designations and of your goals are important to making sure this all works.