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.

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The “Special Needs Trust” - Critical Planning for Family Members with Disability

Wills, Trusts, Durable Powers of Attorney, and Health Care Patient Advocate Designations are all basic tools used in the Estate Planning process. There are also some special purpose tools which are important to consider in any good planning process.

One of the areas we always cover in the initial client meeting is whether there are any family members who have a disabling condition. While we are generally exploring the immediate family, it is worth noting that the considerations important to this area can also be important to more remote family members such as parents, grandchildren, siblings and their children.

The Dilemma For Parents

The classic dilemma for parents of a disabled child is that under our current system of governmental support, the child may not own significant assets; yet caring parents know that one they are no longer their to take care of their child’s needs, there may be nobody else who can do that.

A traditional approach to such planning was to “disinherit” the child and leave his or her portion of the estate to someone else (usually siblings) with the tacit agreement for that person to hold the assets and use them for the child’s benefits. Leaving assets to the disabled child (even in trust) can have devastating impact on that child’s established benefit program (including among other programs, SSI, State Programs, and the all-important Medicaid), by disqualifying them from those benefits.

Traditional trust planning simply doesn’t work (even with a so-called “spendthrift” trust), because these all-important programs are often referred to in legal terms as “necessary services” and traditional trust law allows providers of such “necessary services” to reach even well-drafted spendthrift trusts.

The Special Needs Trust

Most states recognize a special purpose trust, however, generally known as a Special Needs Trust. In Michigan, a properly drafted Special Needs Trust (know as a Michigan Discretionary Trust under Michigan case law) cannot be reached by creditors: even the Michigan Department of Human Services, which administers Medicaid and SSI for Michigan residents. In recent years, estate planners working in the relatively new field of “Elder Law,” have used these trusts in their quest to assist elder residents of Long Term Care facilities to qualify for Medicaid, while protecting their assets. There has been a rather long history of government measures tightening the rules on these trusts so that their use has become much more limited.

However, Congress has carefully limited these measures’ application to the true, third-party Special Needs Trust for the developmentally disabled community. In this context they remain completely viable and are still (in most cases) the most effective planning tool to provide for disabled children. Indeed, in one of the more sweeping congressional acts, the legislative history not only specifically addressed the continuing viability of these trusts for disabled children, but actually enhance their use by creating another favorable exception.

The advantage of the Special Needs Trust is that parents can leave substantial assets, in Trust, for the benefit of their child without exposing them to the risks of the above-mentioned, more traditional approach. There were always the concerns that the sibling would die, become disabled themselves, have legal problems (such as bankruptcy or divorce), all of which would put the assets intended for the disabled child at risk. In a word, there was a lack of certainty. The Special Needs Trust provides that certainty, by assuring that the sibling can be “in charge of” the assets without owning them. It can provide also for succession of management.

It is important to understand the legal implications of this trust. “Disinheriting” a child is a very emotional hurdle. But good planning doesn’t really disinherit - at least not morally. Rather, it ensures that the child will continue to receive (often essential) governmental benefits, while the “inheritance” intended for them is preserved, to be used for those very things the parents are doing for their child while they are still living.

Care must be taken, both in the creation of a Special Needs Trust and in its administration. The primary important point is that the Trust language establish the intent of the grantor(s) that the asset not belong to the child, but that it be used for very specific and limited purposes for the benefit of the child. Once activated, the Trustee must understand the rules, in order not to jeopardize the status of the Trust. An “active” special needs trust will be scrutinized by the Michigan Attorney General’s office, so it is critical that it be drafted by someone with knowledge and experience in this area. And, because of this requirement (relatively recent), we currently generally structure these trust as “stand-alone” documents rather than as part of a general family trust document.

The Traditional Third Party Special Needs Trust

There are two different Special Needs Trust recognized by the government as effective. The traditional Special Needs Trust is a “third-party” trust. In other words, it is created by a person or persons who have no legal responsibility to provide for the beneficiary and is established in such a way that the beneficiary has no legal right of withdrawal for any reason. Distributions from the trust are solely at the discretion of the Trustee. It is critically important that such trusts never be “tainted” with assets that in any way or at any time “belong” to the disabled person (thus, benefit payments and inherited assets should not be used to fund the trust). There may be ways to use such assets creatively and that should be discussed with an expert.

The Payback Trust

The second variety is what I referenced earlier as an “enhanced” planning capability. The law now provides that a Special Needs Trust may be created with assets belonging to the disabled person; but with some tradeoffs. If the disabled person is under age 65, a Special Needs Trust may be funded with their own assets, as long as the trust provides for a “payback” provision. After the death of the disabled person (or on termination of the trust in some cases for other reasons) this “payback trust” must pay the governmental provider back for its expenditures, first, before distributing assets to other heirs. The benefit of a “payback trust” is that it allows the disabled person to qualify (or remain qualified) for governmental benefits without any interruption. In the meantime, the assets within the trust can be managed and used for the benefit of the disabled child during their lifetime.

It is important that these two types of Special Needs Trust be distinguished and where applicable done separately (it is not unusual to have both types in place for clients where it is appropriate). We have effectively established “payback trusts” to hold the proceeds of law suits. We have also had good success with our local Probate Court jurisdictions in converting Conservatorship and Guardianship assets into “payback trusts.”

Our standard trust documents contain a “catchall” provision that provides that any time a distribution is to be made to a person with a disabling condition, it may be paid to the trustee of an existing Special Needs Trust or held as a Special Needs Trust for that person.

If you have a family member with a disabling condition, have had concerns about their ultimate welfare, and have not consulted with an Estate Planning Professional about a Special Needs Trust, this is a clear opportunity to put some essential planning in place and achieve peace of mind.

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