By Peter Reiss
Effectively Naming an IRA or Retirement Plan Beneficiary
“Testamentary Substitutes” or assets with beneficiary designations do not pass under your Will. One of the first things I tell my estate planning clients is that their Wills may not control the disposition of all of their assets. For example, if a couple owns real estate or a brokerage account as Joint Tenants with Right of Survivorship (“JTWROS”), the ownership of the asset will automatically pass on the first death to the surviving joint tenant. Similarly, if an asset has a TOD (transfer on death) or POD (payable on death) designation, and the designated transferee or payee survives the owner, that asset will automatically upon the death of the owner pass to the designated payee or transferee. These forms of ownership are sometimes referred to as “testamentary substitutes”, because they pass outside of the owner’s or joint tenant’s will. Of course, upon the death of the surviving joint tenant, or if the designee of a POD or TOD account predeceases the owner, the disposition of the asset would be subject to the terms of the surviving joint tenant’s or the owner’s Will. So even if you believe that all your assets will either pass by joint tenancy or pursuant to a TOD or POD designation, you should still have a Will to control the disposition of any assets that inadvertently are not subject to these designations.
Most IRAs, 401(k)s and qualified retirement plans have beneficiary designations, which name a specific beneficiary or beneficiaries to receive the assets upon the death of the account owner. The same is true for many life insurance policies.
For various reasons, some people name their estate or a trust as primary or contingent beneficiaries of their life insurance policies or retirement accounts. One reason to do this might be that the owner has many children or the owner’s children are young when they complete their beneficiary designation. In this case, the Will would control the disposition of the assets — for example, split them 5 ways if the owner has five children — or put the assets into a trust for all of the children, directing a schedule of payouts dependent on the children’s ages. While these ideas are good theoretically, there are legal and tax reasons why neither is a good idea, especially in the case of a retirement account.
Naming an estate as beneficiary of a retirement account – or not naming a beneficiary, in which case your estate would be the default beneficiary – is not ideal, because IRS regulations require the retirement account to pay out relatively quickly – in most cases within 5 years. The 5-year payout is mandated when the deceased account owner was under 70 ½ or still working at death. If the account owner was over 70 ½ at death, the payout will be taken over her or his remaining life expectancy, which may exceed 5 years but will be far shorter than the participant’s child’s or grandchild’s actuarial remaining life span. For example, the relevant table provides that a 75-year old has a life expectancy of 13.4 years.
An abbreviated payout is troublesome because distributions from most retirement accounts (except for Roth IRAs) are taxed as ordinary income, since the contributions were not subject to income tax when they were made. A $500,000 IRA, for example, payable to an estate would have to be distributed in 5 years. The income tax on a distribution of $100,000 per year would be substantial. If on the other hand an individual or a certain type of trust is the beneficiary, the individual or trust can “stretch” the distributions over his or the trust beneficiary’s lifetime (as determined by IRS actuarial tables). . In the case of a large retirement account with a youthful beneficiary, the difference can be substantial. Also, any funds not distributed will remain in the retirement account to grow tax-free.
The most favorable income tax treatment allows the distribution of the retirement account to be “stretched” over the life expectancy of a “designated beneficiary” provided the payout begins on or before December 31 of the year following the account owner’s year of death (the account owner or his or her estate must take the regular minimum distribution in the year of death). This is the case even where the deceased account owner was under 70 ½ or still working at his or her death – situations that would otherwise call for a maximum 5-year payout.
A “designated beneficiary” is an individual whose identity is determinable by September 30 of the year following the account owner’s death, or certain trusts. An estate cannot be a designated beneficiary; neither can a charity – neither has a life expectancy. A trust may be “looked through”, and its beneficiary’s life expectancy used in determining the length of the stretch out, if (i) the trust is valid under state law, (ii) the trust is irrevocable or will be on the death of the original retirement account owner, (iii) the trust’s beneficiaries all qualify as “designated beneficiaries” and (iv) specified “trust documentation” must be provided to the retirement plan administrator by October 31 of the year following the original account owner’s death.
Note that if a qualified “see-through” trust has more than one beneficiary, the age of the oldest beneficiary will be used in determining the relevant life expectancy and therefore the length of the “stretch”. For this reason, if there is more than one beneficiary, a separate trust should be established for each of them. Note also that if even one of several trust beneficiaries is not a “designated beneficiary”, for example is a non-“see through” trust or a charity, no beneficiary will qualify for the stretch-out and you are back to the less-beneficial “default” rules (five years or the account owner’s life expectancy). One way out of this: if the non-qualified beneficiary is paid out and no longer a trust beneficiary by September 30 following the original account owner’s death, that beneficiary will be “ignored” and the trust will qualify.
This is just a summary and is not legal advice. Please consult an attorney when making retirement plan beneficiary designations, especially if you are considering using one or more trusts.