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Who Should Be Beneficiary of Your IRA and Tax-Deferred Plans?

IRAs, 401(k)s, 403(b)s, pension, profit sharing, Keogh and other tax-deferred plans were created to encourage you to save for your retirement. They are called tax-deferred plans because you did not pay income taxes on this money when the contributions were made. The income taxes are deferred until you withdraw the money at a later time—ideally, at your retirement when your income (and tax bracket) are lower.

You cannot leave your money in these accounts forever. At a certain point (your required beginning date), Uncle Sam says you must start taking money out. Generally, this is April 1 following the year in which you become age 70 1/2. However, if you have money in an employer plan (pension, profit sharing, etc.)you continue working beyond age 70 1/2 and you own less than 5% of the company, you can delay your required beginning date on those accounts until your actual retirement date. (This exception does not apply to IRAs.)

Determining the amount you are required to take out each year (your required minimum distribution) is much easier now than it used to be. Each year you divide the year-end value of your account by a life expectancy divisor found on The Uniform Lifetime Table as provided by the IRS. The result is your required minimum distribution for that year.

For example, the divisor for age 72 is 25.6. If your year-end account balance is $100,000, you divide $100,000 by 25.6. The amount you are required to withdraw for that year, then, is $3,906.25.

You can withdraw more than the required minimum distribution amount at any time. But if you don’t need all of your money, or if you die before you use it all, you’d probably like to let it continue to grow tax-deferred for as long as you can, with as much as possible going to your spouse and/or children, and as little as possible going to taxes.

For years, this was difficult to do because the rules governing these distributions were complicated and confusing. But in 2001 and 2002, the IRS changed many of the rules, finalized the regulations (which had been temporary for several years) and actually made it easier to get the results you want.

You cannot change the ownership of your tax-deferred plans to your living trust. You can, however, name your living trust as the beneficiary. But before you do, be sure to consider all of your options. As you will see in the next few pages, whom you name as beneficiary will have a significant impact on how long the tax-deferred growth can continue, and how much of your tax-deferred savings will go to Uncle Sam in income and, possibly, estate taxes.

While not every possibility is covered in this section, the following information will help you begin to understand the basics of this planning. Be sure to seek guidance from an attorney who is experienced in planning for these assets, especially if your estate is significant and/or you have significant amounts in tax-deferred plans.

Most married people, especially those who have been married for some time, name their spouse as beneficiary. In many cases, this will be your best option. The two main reasons are 1) the money will be available to provide for your surviving spouse, and 2) it gives you the spousal rollover option.

Also, if your spouse is more than ten years younger than you are, you can use a different life expectancy chart that will make your required distributions less. (This lets the tax-deferred growth continue longer on more money.)

Here’s how the spousal rollover option works. If you die first, your surviving spouse can “roll over” your tax-deferred account into his/her own IRA, further delaying income taxes until your spouse must start taking required minimum distributions at his/her required beginning date. When your spouse does the rollover, he/she names a new beneficiary(ies)—preferably much younger ones, as your children and grandchildren would be.

After your spouse dies, the beneficiary’s actual life expectancy will be used for the remaining required minimum distributions. Depending on the beneficiary’s age at that time, that could mean decades of tax-deferred growth.

For example, let’s say your grandson is 20 when he inherits a $100,000 IRA from your spouse. Assuming a 7% annual return, and that he takes out only the required minimum distribution each year, over the next 63 years (the life expectancy of a 20-year-old), this $100,000 IRA will provide your grandson with over $1.7 million in income!

What if you name your spouse as beneficiary and your spouse dies before you? Under the old rules, this was often a problem. Unless you remarried, you lost the spousal rollover option. You could name a new beneficiary, but the distributions after your death were still based on your and your deceased spouse’s life expectancies. But now, if your spouse dies first, you can name a new beneficiary—and after you die, the distributions will be based on the new beneficiary’s life expectancy.

Possible Disadvantages

There are some possible disadvantages of naming your spouse as beneficiary that you need to consider. Keep in mind that, after you die, your spouse will have full control of this money, which may not be what you want. You may have children from a previous marriage or feel that your spouse may be too easily influenced by others after you’re gone.

Your spouse doesn’t have to do a rollover; a lump-sum distribution could be very tempting, even though all of the income taxes would have to be paid at once. If your spouse becomes incapacitated, the court could take control of this money. The money could also be lost to your spouse’s creditors.

If your estate is large enough to pay estate taxes and most of your estate is made up of your tax-deferred savings, naming your spouse as the beneficiary could cause you to waste some or all of your exemption. (If you have other assets that can be applied to your exemption this might not be a problem.)

If your spouse will have plenty of assets—or if you have reason to believe your spouse will die before you—you could name your children, grandchildren or other individuals as beneficiary(ies).

The tax benefits can be great. Because you are not leaving this money to your spouse, your estate tax exemption can be applied to it, which could save estate taxes. And if your beneficiary is much younger than you (as your children and grandchildren would be), you can “stretch out” the tax-deferred growth over their life expectancies.

Possible Disadvantages

Any time you name an individual as a beneficiary, you lose control. After you die, your beneficiary can do whatever he/she wants with this money, including cashing out the entire account and destroying your carefully made plans for long-term, tax-deferred growth. There is the risk of court interference if your beneficiary is a minor or becomes incapacitated.

And then there are a beneficiary’s creditors. Money that has been withdrawn has always been considered to be available to a beneficiary’s creditors, spouse, and ex-spouse(s). But in 2014, the Supreme Court ruled that the entire inherited IRA is available to a beneficiary’s creditors in bankruptcy court.

The justices reasoned that because the beneficiary cannot make additional contributions or delay distributions until retirement, an inherited IRA is not a retirement account of the beneficiary. There is, in fact, nothing to prevent the beneficiary from withdrawing funds, or even clearing out the account, at any time. Therefore, these funds must also be available to satisfy the beneficiary’s creditors during bankruptcy. Following the same logic, an inherited IRA is also subject to divorce proceedings.

One more note of caution: If you leave a substantial amount to a grandchild, it could be subject to the generation-skipping transfer tax, which is equal to the highest estate tax rate in effect at that time and is in addition to estate and income taxes.

Naming a trust as beneficiary will give you maximum control over your tax-deferred money after you die. That’s because the distributions will be paid not to an individual, but into a trust that contains your written instructions stating who will receive this money and when. Using a trust as beneficiary will allow the tax-deferred growth to continue over a beneficiary’s life expectancy and protect your hard-earned savings from the beneficiary’s creditors and/or irresponsible spending.

For example, your trust could provide income to your surviving spouse for as long as he or she lives. Then, after your spouse dies, the income could go to your children or grandchildren.

While you are living, the required minimum distributions will be paid to you over your life expectancy. After you die, the distributions can be paid to the trust over the life expectancy of the oldest beneficiary of the trust. Just as you can do now, the trustee of your trust will be able to withdraw more money from the tax-deferred account(s) if needed to follow your instructions, but the rest can stay in the account(s) where it is protected and growing tax-deferred.

Possible Disadvantages

You will not be able to provide for your spouse and stretch out the tax-deferred growth beyond your spouse’s actual life expectancy. That’s because you must use the life expectancy of the oldest beneficiary of the trust which, in this case, would probably be your spouse.

Also, many trusts pay income taxes at a higher rate than most individuals, but this only applies to income that stays in the trust. (With a revocable living trust, this would apply only after you die.) Distributions from your tax-deferred account that are paid to the trust are subject to income tax, and if they were to stay in the trust, the higher tax rates would apply. But usually this is not a problem because the trustee has authority to distribute the income to the beneficiaries of the trust, who then pay the income tax at their own (usually lower) rates.

Finally, in order for a trust to qualify as beneficiary of a tax-deferred account, it must meet certain IRS requirements:

  • It must be valid under state law.
  • It must be irrevocable or become irrevocable at your death.
  • The beneficiaries must be individuals (no charities or other non-persons) and they must be identifiable from the trust document.
  • A copy of the trust document and any subsequent revisions must be provided to the Plan Administrator or IRA trustee, custodian or issuer.

Revocable Living Trust or Stand Alone Retirement Trust?

A revocable living trust becomes irrevocable at your death, so it would meet the requirements above. But because the trust’s oldest beneficiary’s life expectancy must be used to determine the distributions, many attorneys now recommend a separate share, or even a separate trust, for each beneficiary. These are called “stand alone retirement trusts” because they are created solely for retirement plan and IRA assets. (A revocable living trust would still be used for your general estate planning purposes.)

Here are some terms you should know:

conduit trust requires that all distributions from the IRA or retirement plan must be distributed to the trust’s beneficiary(ies). The trust simply acts as a “conduit” from the plan to the beneficiary. These distributions are not protected from a beneficiary’s creditors and provide no asset protection.

An accumulation trust allows the distributions to be kept within the trust instead of being distributed to the beneficiary. Assets that remain in the trust are protected from the beneficiary’s creditors, but any undistributed income kept in the trust will be subject to the higher income tax rates. (An accumulation trust is usually used to provide for a special needs beneficiary so that government benefits are not jeopardized.)

trust protector can be given the power to change from a conduit to an accumulation trust. This can be valuable if there is a change in the beneficiary’s circumstances (due to disability, divorce, dependency issues, etc.) that would make it desirable to keep the distributions in the trust.

If you are planning to leave an asset to charity after you die, a tax-deferred account can be an excellent asset to use. That’s because when you name a charity as the beneficiary, there will be no income or estate taxes on this money after you die.

If you name a charitable remainder trust as beneficiary, your spouse, children, or others can receive an income for a set number of years or for as long as they live—and you can still save income and estate taxes. You can also set up your own charitable foundation and have the foundation pay your kids a salary to run it. (See Part Nine for more information about these.)

The only downside of naming a charity as beneficiary is that it has no life expectancy. Under the old rules, if you named a charity as beneficiary, you had to use just your life expectancy when determining distributions during your lifetime. This made the distributions larger than they would have been with another beneficiary. But now, even with a charity as your beneficiary, you still use the Uniform Lifetime Table to determine your required minimum distributions, so this is not the problem it used to be. However, you still need to be aware of a charity’s “zero”  life expectancy, as you will see next.

You don’t have to choose just one of these options. You can split a large IRA into several smaller ones and name a different beneficiary for each one. If your money is in an employer plan, you can roll it into an IRA and then split it.

You could name several beneficiaries for one IRA, but then you must use the life expectancy of the oldest beneficiary for the entire IRA, just as when you use a trust as beneficiary. This is especially important if a charity is involved. Remember, it has a life expectancy of zero, so the IRS would consider it the oldest beneficiary. Depending on when you die, this could cause the entire IRA to be paid out in just five years.

With separate IRAs—one for each beneficiary—you can use each one’s life expectancy. This will give you the maximum stretch out over all their ages. It will also be more fair to your beneficiaries, especially if there is a wide difference in their ages, or if you want to include a charity. (A stand alone retirement trust for each beneficiary is still advantageous.)

When should you divide a larger IRA? That will depend on your planning decisions. Doing it now, while you are living, is the cleanest approach. If you die first, your surviving spouse can also split your IRA when he/she does a rollover and names new beneficiaries. And now, under the new rules and under certain circumstances, your IRA can be divided into separate accounts in the year after you die.

Setting up separate IRAs now will make it a little more complicated for you when calculating your required minimum distributions each year, because one will have to be calculated for each IRA. But you can take the total of your distributions from any IRA you wish. If your estate is substantial, dividing a large IRA can also help you use your estate tax exemption more effectively.

Note: Any time you name someone other than your spouse as the beneficiary, you need expert advice. You’ll need to find an attorney who is experienced in this area, especially if you have large amounts in these plans. Also, your spouse may need to sign a consent form. Even in noncommunity property states, spouses now have rights to retirement plan and other benefits.

If you are not married, your decision will be less complicated. You can name any individual, a trust, or a charity as the beneficiary. If you want an individual to receive this money after you die, consider using a trust to keep more control. And make sure the individual is aware of the rules for an inherited IRA.

Before you make a decision, consider all of your options carefully, especially if you have a sizeable amount in your tax-deferred plans.

What happens if you die without a valid beneficiary? That depends upon when you die. If you die before your required beginning date, your account must be paid out within five years. If you die after your required beginning date, distributions will be paid over the remaining years of your “fixed life expectancy,” determined from an IRS table based on your age in the year you die. In either case, the proceeds would have to go through probate to determine who is entitled to receive these benefits.

With the new rules, you can change your beneficiary at any time while you are living and the distributions after you die will be paid over that beneficiary’s life expectancy.

In fact, your final beneficiaries do not have to be determined until September 30 of the year after you die, which allows for some neat clean-up planning to be done after you’re gone. For example, your spouse could disclaim (refuse) some benefits so a grandchild could inherit. No new beneficiaries can be added after you die, however, so you must be sure to name all appropriate beneficiaries while you are living.

To change the beneficiary of employer-sponsored plans (such as a 401(k), pension, or profit sharing plan), contact your employee benefits or personnel department for the proper form. To change the beneficiary of your IRA or Keogh, you will need to contact the institution where your account is located.

Some plans have restrictions on what you can do on the beneficiary designations. Be sure to read the document carefully. If the plan will not let you do what you want to do, consider rolling your money into an IRA as soon as you can. (However, some states provide less creditor protection for IRAs than for other types of tax-qualified plans, so be sure to check first.) If your money is already in an IRA and the institution will not agree to what you want, consider moving your IRA to another institution.

If you qualify, you may want to consider converting some or all of your tax-deferred money to a Roth IRA. You can only convert from a traditional IRA, so if your money is in a different tax-deferred plan, like a pension or profit sharing plan, you must first roll your money into a traditional IRA and then convert it to a Roth IRA. You will have to pay ordinary income taxes on the amount when you convert. Why go to all this trouble? Because it can be worth it. Here’s why:

  • Unlike a traditional IRA that requires you to start taking your money out at age 70 1/2, with a Roth IRA there are no required minimum distributions during your lifetime. So you can leave your money there for as long as you wish.
  • Unlike a traditional IRA, you can continue to make contributions to a Roth IRA after you have reached age 70 1/2.
  • As a general rule, after five years or age 59 1/2 (whichever is later), all distributions to you and your beneficiaries will be tax-free.
  • You can stretch out a Roth IRA just like a traditional IRA. After you die, distributions can be paid over the actual life expectancy of your beneficiary. Your spouse can even do a spousal rollover and name a new beneficiary.

Your tax advisor can help you determine if converting to a Roth IRA would be a good move for you.