The Importance of Beneficiary Designations for Your Retirement Assets

Over the last decade, many clients’ portfolios have shifted from being “probate heavy” (i.e. with most assets passing under one’s Will) to “non-probate heavy” (i.e. with most assets passing outside of one’s Will).  The reason for this is the accumulation of wealth in retirement plan assets, such as IRAs and 401(k) accounts. These retirement assets do not pass under the terms of one’s Will, and therefore are “non-probate”assets. Rather, these assets pass as dictated by the plan participant on his or her beneficiary designation form.

 

Designating one’s beneficiaries can be very simple or can present a series of complex issues. The most simple and straight forward situation is one in which a client has a spouse and one or more adult children, none of whom has special needs or circumstances that might be impeded by being named as a retirement plan beneficiary. In this case, the plan participant likely will name the spouse as the primary beneficiary and the children as secondary beneficiaries, each entitled to an equal share. If the plan participant is the second spouse to die, each adult child will most likely be able to take the annual required minimum distributions (RMDs) based on his or her own life expectancy, thereby taking advantage, to the extent possible, of income tax deferral.

 

If instead the client has minor children at the time he is establishing an estate plan, the client might name one or more custodial accounts as the designated secondary beneficary(ies) of the retirement assets. The annual RMD would be paid from the inherited retirement account to the custodial accounts. However, this presents a risk in that, upon attaining the age of 18 years, a child could demand the entire principal of the inherited retirement account, thereby being forced to pay income tax on the entire balance in one year rather than limiting the annual income tax to that imposed on the RMD.

 

One possible solution to this problem is to name a Trust under one’s Will for  minor children as the secondary beneficiary of the retirement assets. However, this seemingly simple solution actually raises several complicated issues. Two general questions that should be examined before naming a trust under Will as beneficiary are as follows:

 

1. Does the Will establish one trust for all minor children, or individual trusts for each child/Who will be the measuring life to determine the RMD?

 

2. Does the trust require income to be distributed or does the trustee have full discretion to distribute or accumulate income/will income taxes be imposed at individual rates or at the more compressed trust tax rates?

 

Determining the Measuring Life: Clients often desire to establish a single trust for all of their children until such time as the youngest child is no longer a minor. The reasons for this vary, but generally are based on the notion that it is difficult to tell whether one or more minor children will have greater medical and/or financial needs than the client’s other children. If such a trust is named as the beneficiary of an IRA, the IRS rules require that the RMD be based on the life expectancy of the oldest child. Thus, if a client has a 3 year old child, a 5 year old child and a 16 year old child, the RMD will be based on the shorter life expectancy of the 16 year old. Accordingly, the shorter the life expectancy- the larger the RMD- the greater the amount of income tax imposed over a shorter period of time.

 

If instead the Will establishes individual trusts for each child, the RMD would be calculated separately for each child based on his or her own life expectancy. Moreover, a single trust for each child, with mandatory income distributions to the child or to a custodial account for his or her benefit will insure the best possible income tax treatment (as discussed further below).

 

But, beware of an easy trap to fall into! The beneficiary designation for the retirement asset must state that one share is to be distributed to each separate trust under the client’s Will. If, instead, the beneficiary designation states “to the trusts under my Will for my children,” the IRS will nonetheless look to the oldest child as the measuring life with respect to determining the amount of the RMD.

 

Another trap with even more severe consequences is having a trust that names a much older contingent beneficiary. For example, if a trust which is established for the benefit of a child provides that upon that child’s death, any remaining assets pass to the child’s descendants, but if there are none, to child’s great uncle Bob, who is 90 years old. Despite strong evidence that Uncle Bob will never receive the asset, the IRS may look to him as the measuring life.

 

Imposition of Income Tax: Once the measuring life for the RMD is determined based on whether there is a single trust or several individual trusts, consideration must be given to the income tax consequences of having retirement assets payable to one or more trusts.

 

A trust which mandates income distribution to the beneficiary(ies) is considered a “conduit” trust for income tax purposes. Any income that is earned by or received into the trust merely passes through to the beneficiary and will be taxed at his or her individual income tax rates, which are generally much lower and hence, more favorable, than the tax rates imposed on a trust’s income. When retirement assets are payable to a trust, the entire RMD is considered income for IRS purposes. Therefore, if a trust is named as the beneficiary of retirement assets and if, by its terms, requires income to be distributed to the trust beneficiaries, the income tax imposed on the RMD will be minimized to the extent possible.

 

However, when it comes to minor children, clients are often fearful of establishing trusts which require the income to be distributed, and therefore prefer “discretionary trusts.” If the trust is discretionary as to income (i.e. the trustee is not required to distribute the income to the minor children), the RMD will accumulate in the trust and be taxed at the trust’s compressed income tax rates, unless the trustee chooses to pay it out to the beneficiary during the year. Indeed, trust income in excess of just over $11,000.00 is taxed at the highest individual income tax rate.

 

To avoid this unintended tax result, the trust can direct that the RMD be distributed to  separate custodial accounts for each minor child. This will result in the imposition of income tax at individual, rather than trust, rates. However, as noted above, at age 21, the beneficiary will be entitled to withdraw the entire custodial account (but, depending on the trust terms, not the entire principal of the inherited IRA as shown below).  This may or may not be of concern to a client, but should be taken into consideration.

 

Some clients view their retirement plan assets as an on-going “nest-egg” for their heirs. These clients might name one or more trusts with the following requirements as the beneficiary(ies) of the retirement assets:

 

1. RMDs are to be paid to a custodial account while the beneficiary is a minor;

 

2. RMDs are to be paid outright to the beneficiary upon attaining majority age;

 

3. Principal is to be used only at the trustee’s discretion until the beneficiary attains certain ages (i.e. 25/30/35 or older) or for the beneficiary’s entire lifetime.

 

This plan would minimize the amount of income tax imposed on the annual RMDs (i.e. tax would be imposed at the beneficiary’s individual income tax rate) and would give the beneficiary the right at age 21 to access the amount of the RMD accumulated in the custodial account plus the right to receive each annual RMD thereafter. The beneficiary will not be able to take premature distributions from the remaining principal of the retirement account without the trustee’s approval until the termination of the trust term (i.e. if the trust is to terminate when the beneficiary attains a certain age).

 

In conclusion, clients are faced with having to weigh the amount of control they want to impose with respect to leaving retirement assets to their heirs against the IRS’ competing desire to impose the maximum amount of income tax on those assets as soon as possible. Clients should discuss their priorities with their attorneys so that the beneficiary designations for the retirement assets and the estate plan, including the Wills and any trusts thereunder, are in-sync and focused on achieving the client’s goals.

 

In an upcoming article in this series, the author will present the issues and potential solutions to naming a beneficiary with special needs as the recipient of retirement plan assets.