Who should be named as beneficiary of retirement accounts? This question arises in almost every estate plan, and too often it can be dodged and handed off to the financial planner. Or even worse, because the planner is unsure of the ins-and-outs of the decision, he does not fully explain the concept to his client but, instead, makes the decision for him.
The tax regulations in this area are complicated, and many commentators, in an effort to be accurate, make the answer seem impossible to discern. A planner’s research can leave him more confused. The most important principles, however, can be steeped down to a simple set of rules which will guide the advisor or the IRA owner to the right beneficiary designation in all but the most complicated estates.
Why Does the Beneficiary Designation Matter so Much? The time value of money is well-understood. Pair that with a non-taxable vehicle for growth, and the combined benefit is unmatched in the world of saving and investing. Savings held and grown inside an IRA will increase in value exponentially compared to funds held in regular savings or investment accounts.
Often in my estate planning practice I am asked, “How much tax will my children pay on their inheritance?” This is one of the few instances in the taxation arena where I can offer good news! As a general rule, you do not have to pay income tax on assets or funds you receive by inheritance. Internal Revenue Code (“IRC”) section 102(a). An exception to this rule is your receipt of distributions from a retirement account when you are the beneficiary of the deceased account holder. Because of the income tax-favorable treatment those assets received during the account holder’s life, the eventual payout triggers an income tax. IRC section 402(a). (A tax-exempt entity is an exception to this rule, which can make them a good candidate for beneficiary status.)
Because the receipt of this type of inheritance is subject to income tax, carefully timing the receipt of retirement fund distributions to delay the payment of the tax can significantly affect the net benefit received by the beneficiary over time. By making correct beneficiary designations now on your Individual Retirement Accounts (“IRAs”), you can give your beneficiaries better options for timing the receipt of the funds after your death, and therefore deferring the income tax. This can save or waste many thousands of dollars over the life of your beneficiary.
As always in estate and financial planning, however, every family’s personal dynamic is just as important, or more important, than the tax result. For example, many families have an adult child whom they would not want to receive any substantial sum of money, no matter what the tax cost. Do not substitute your decision for your client’s, but explain the alternatives and offer to re-visit the decision a few years down the road.
Risks Inherent in Incorrect Beneficiary Designations Incorrect beneficiary designations on your retirement accounts, which may hold a major portion of your family’s wealth, may cause the account to be distributed rapidly, forcing contemporaneous payment of income taxes, usually at higher pre-retirement income tax rates. The worst case scenarios in naming IRA beneficiaries include:
• failing to name a beneficiary on the retirement account;
• naming “my estate;” or
• naming a trust which does not meet the IRS requirements to be a “qualified trust.”
The first two designations miss the opportunity to keep this asset out of probate; and all three of them eliminate the possibility for your spouse and children to delay distributions and payment of taxes, as distribution from the account likely will be required within five years.
Benefits of Correct Beneficiary Designations Contrast the above dire results with the benefits that proper beneficiary designations can allow:
• Your spouse could convert your IRA into his own IRA, which could accept additional contributions from the spouse, and which will enjoy tax-free growth and deferral of taxes over your spouse’s life expectancy; Treas. Reg. § 1.408-8 Q&A 5(a), or
• Your children or spouse (or other named individuals) could set up “inherited IRA” accounts, with tax-free growth and deferral of taxes on distributions made over their own life expectancy; Treas. Reg. §1.401(a)(9)-3 Q&A 5, Treas. Reg. §1.401(a) (9)-4 Q&A 4(b), and Treas. Reg. §1.401(a)(9)-5 Q&A 5(c)(2); and multiple individual beneficiaries may be able to create separate accounts; Treas. Reg. §1.401(a)(9)-3 Q&A 1(a), Treas. Reg. §1.401(a) (9)-5 Q&A 7(a).
• A “qualified trust” beneficiary (explained below) can set up an inherited IRA account, with tax-free growth and deferral of taxes on distributions made over the life expectancy of the “designated beneficiary;” Treas. Reg. §1.401(a)(9)-3 Q&A 1(a), Treas. Reg. §1.401(a)(9)-5 and Treas. Reg. §1.401(a)(9)-8, or
• A charity as beneficiary can receive the entire account and pay no income taxes, while your estate benefits from an estate tax charitable deduction. Treas. Reg. §1.401(a)(9)-3, Treas. Reg. §1.401(a)(9)-5. NOTE: inherited IRAs cannot accept additional contributions from the beneficiary.
So — Who Should Be Named as Beneficiary of Retirement Accounts? Even if you are not an estate planner, you must know this answer for your own financial plan.1 The answer to this important question depends on several factors. The choice of beneficiary is made by examining how the proposed beneficiary must or may receive distributions from the account after your death. Some factors are known — and some are unknowable when the designation is made. An example of a factor that may be unknowable is whether you will die before or after the date on which you must begin taking distributions (termed the “Required Minimum Distribution” and the “Required Beginning Date.”) Whether your death occurred before or after your RBD sometimes affects the beneficiary’s choices. Treas. Reg. §1.401(a)(9)-3, 5 and 8.
Even the known factors may leave you standing “between a rock and a hard place,” trying to choose between designations that don’t quite meet all of your family concerns or tax objectives. As always with estate planning, it is better to have an imperfect plan in place than no plan at all — and the plan can be adjusted as more factors become known in the years ahead.
Best Case Scenario – Spouse as Beneficiary We can begin with one very helpful general rule: Although you may name any person, group of persons, a trust, a charity or other entity as beneficiary of a retirement account, your spouse will always enjoy the most favorable array of options for dealing with the funds in your retirement account2. The spouse is the only beneficiary who can create a “Rollover IRA” into his or her own IRA, where additional deductible contributions may be made and distributions can be delayed until the spouse reaches age 70½. Treas. Reg. §1.408-8 Q&A 5(a).
Or, if the funds are needed currently, the spouse can set up an inherited IRA to take current distributions according to her life expectancy. The distributions will begin when you would have reached age 70½; or if you were past your RBD at your death, your spouse’s distributions from an inherited IRA will begin in the year following the year of your death. Treas. Reg. §1.401(a)(9)-3 Q&A 3(b), Treas. Reg. §1.401(a)(9)-5 Q&A 5. In this way, even if your spouse is too young to withdraw from her own IRA (younger than 59½), the withdrawals from your IRA will suffer no penalty for withdrawal at her younger age.
Non-Spouse Individual(s) as Beneficiary This beneficiary also can establish an inherited IRA, with payout over his own life expectancy. Treas. Reg. §1.401(a)(9)-3 Q&A 1(a) and Treas. Reg. §1.401(a) (9)-3 Q&A 3(a). Distributions must begin by December 31st of the year following the year of your death. If separate inherited IRAs are established for several individual beneficiaries (“separate accounts”), each beneficiary’s life expectancy can be used for distributions, so that the period of tax deferral is extended, if time restrictions for electing this option are met. Treas. Reg. §1.401(a)(9)-5 Q&A 7(a). NOTE: Separate account treatment is not available to the several beneficiaries of a trust named as IRA beneficiary.
Trust as Beneficiary To quote an old adage: “Don’t let the tax tail wag the dog.” Too often, people make poor economic decisions because their judgment is clouded by tax concerns which are probably being overemphasized by well-meaning financial advisors. In many financial and estate planning decisions, the tax consequences are a secondary consideration. This is not because tax planning is irrelevant or unimportant — it is just that in the realm of personal financial planning, you should make decisions first based on the wisdom of the investment, retirement, or estate planning strategy, and then take a look at the taxes. Too often in the case of IRA beneficiary designations the planner resorts to a hard and fast rule: Do Not Name a Trust as an IRA Beneficiary. This is admittedly a tax-favorable, general rule. But it does not consider a family’s particular circumstances which may include a disabled child or beneficiaries who, for other reasons, should not be recipients of significant sums of money. These family situations occur too often to use a general rule which omits the possibility of naming a trust as IRA beneficiary, despite the fact that less than favorable tax results may obtain. A trust sometimes is named as beneficiary, usually after the spouse, when the trust’s delayed distribution of income and/or principal to children is a priority, or when an estate tax Credit Shelter Trust established in the living trust must be funded with the IRA because there are insufficient other assets with which to fund it.3 To receive favorable treatment, a trust beneficiary must be a “qualified trust.” See Treas. Reg. § 1.401(a) (9)-4 and 5. With a qualified trust, the trustee can set up an inherited IRA and make investment decisions.
A “designated beneficiary” for the trust will be determined, and that life expectancy will be used for the timing and calculation of the amount of distributions to the trust. The designated beneficiary usually is the oldest trust beneficiary.
Many of the risks associated with naming a trust as beneficiary can be managed. A living trust is not a “qualified trust” under I.R.S. regulations if it has non-individual beneficiaries, including charities, or if certain expenses can be paid from the retirement assets. Other restrictions also apply. NOTE: Even when the trust is a qualified trust, it will pay tax on the IRA distributions it receives at trust income tax rates, which currently are higher than individual rates. Distributions from the trust out to the trust beneficiaries will depend on the terms of the trust, and in some cases, these distributions will mean that the beneficiary instead pays the income tax at his lower rate.
If the trust is not a qualified trust, payout from the IRA will be required within 5 years of death, with resultant accelerated income taxes. Even this result does not remove this alternative from the IRA beneficiary arsenal. Payment of taxes may be preferable to loss of control over cash distributions to a family with issues described above. The tax costs associated with naming a qualified or non-qualified trust as a beneficiary must be weighed against the family benefits. If the trust is merely a probate-avoidance technique, then do not name the trust as beneficiary. If the trust is protecting beneficiaries from dangers associated with current distributions, an IRA owner might accept the income tax costs and choose a trust as beneficiary.
Charity as Beneficiary. Most charitable organizations are tax-exempt — so a charity can be a good choice for beneficiary if you have other assets to leave to your spouse and children. Also, the estate will enjoy a charitable contribution deduction from the estate tax (if applicable4.) NOTE: Naming a group of beneficiaries including charities with individuals is not recommended. It is better to name the charity as beneficiary on one retirement account, and to name your spouse or other individuals separately on another account.
Conclusion — Simple Rules There are many reasons to delay estate planning and the review of beneficiary designations, but the results of bad planning or failure to plan could be financially or emotionally harmful to our families. This one component of estate planning – reviewing beneficiary designations – should be done every five years. Laws change and family dynamics change. What seems best today might be improved at the next pass.
Here, then, are the promised Simple Rules for IRA Beneficiary Designations:
- Name the spouse as primary beneficiary;
- Name the children or other individuals as outright beneficiaries, either primary, or contingent, after the spouse;
- Name a charity as beneficiary on a separate IRA account-do not include a charity in a group of individuals named as beneficiaries on one account;
- If you need to restrict distributions to any individual, name a qualified trust as beneficiary of the IRA, but proceed with caution and with full information on the tax results of this choice. Diary review of this choice within five years.
1 This article addresses traditional IRA accounts – for Roth IRAs the answers may be different. Also, the answers for 401(k) accounts or other company administered programs like 403(b) accounts will follow these general rules, but will be restricted by the terms of the employer plan. For instance, many employer plans do not allow payout over any life expectancy other than the employee’s. To understand the plan’s restrictions, you must read the plan. NOTE: If you do not like the array of possible beneficiaries under an employer plan, once you have the ability to convert the 401(k) – type account into an IRA (after retirement or separation from service) you will be able then to name your preferred beneficiary.
2 In fact, 401(k) type accounts require a spouse to sign a written waiver of benefits if you do not name them as beneficiary. This is critical in second marriages. Without this waiver, naming your children as beneficiary of your 401(k) may be invalid and the spouse will inherit the account.
3 With the use of “portability,” the problems associated with the need to fund the Credit Shelter Trust with IRA assets may be resolved. See I.R.C. §2010(c)(5)(A) and regulations.
4 In 2014, the Illinois estate tax is payable by estates over $4 million; the federal estate tax is payable by estates larger than $5.340 million.
Patricia C. Kraft is a solo practitioner in Woodstock, Illinois. Her practice includes estate and succession planning, and transactions for families and small businesses. Pat graduated from Loyola University School of Law and Northern Illinois University, and she is a member of the Northwest Suburban Estate Planning Council.