Beneficiaries of IRAs or Retirement Plans
by Layne T. Rushforth
Who should be the beneficiary of my IRA or Other Retirement Plan?
Who should be the beneficiary of an IRA or of my qualified plan? The real answer is very personal for each individual, and the answer for you depends on your priorities and your objectives. [For simplicity, the remainder of this article refers to IRAs, but the same general concepts applies to benefits payable under qualified retirement plans, including 401(k) plans and other qualified pension plans.]
Before trying to answer the question, it is important to understand that whoever receives a traditional IRA (not a Roth IRA) will pay income taxes when distributions from the IRA are made. The IRA will be subject to the federal estate tax if the participant's (account holder's) taxable estate exceeds the estate tax "applicable exclusion" and the beneficiary is someone other than one or more qualified charities and/or the account holder's surviving spouse.
If the IRA is distributed in a lump sum and is subject to the estate tax, the combination of the estate tax and income tax can take 70% of the IRA. If that scenario applies to you, you may wish to consider naming one or more qualified charities as the beneficiary of your IRA. Roth IRAs are usually not subject to the income tax, but they are still subject to the federal estate tax laws.
"Stretch IRAs" and RMDs.
One significant benefit of an IRA is the ability to accumulate income in a tax-free environment. Although distributions will eventually all be taxed, the investments can compound tax free until the distributions are actually made. Because of that, it is prudent for a beneficiary of an IRA to take only the minimum distribution required by law each calendar year, which is called the "required minimum distribution" or "RMD". When the IRA account holder dies, the beneficiaries can take required minimum distributions, which are calculated to pay out the IRA over the beneficiary's life expectancy. If one IRA has three beneficiaries, the required minimum distribution is calculated using the oldest beneficiary's life expectancy. (Using the oldest beneficiary's life expectancy can be avoided by dividing the IRA into a separate subaccount for each beneficiary. If that is done, the RMD for each beneficiary's subaccount can be based on the beneficiary's own life expectancy.) The technique of having a beneficiary take payments over their life expectancy is referred to as a "stretch IRA" because it is stretched over the beneficiary's life expectancy. The "stretch IRA" technique only works with human beneficiaries and "qualified trusts".
Using A Trust as a Beneficiary.
While it may be prudent to use a "stretch IRA" technique, some beneficiaries do not have the self-discipline to receive the IRA in installments when they have the power to take it in a lump sum. An IRA payable to a beneficiary who has unpaid creditors may lose the IRA to those creditors in legal proceeds. So, if you want to use a "stretch IRA" with impatient, imprudent, or debt-burdened beneficiaries, it might be appropriate to designate a trust as the IRA beneficiary. It is possible to do that, but to qualify for optimal income-tax treatment, the trust must be a "qualified trust" that meets these requirements:
The trust must be a valid trust under state law;
The trust must be irrevocable on or before death of the owner of the IRA;
The trust beneficiaries (as to the IRA) must be living human beings who are readily determinable from the trust instrument; and
The trust document must be provided to the IRA plan administrator.
If the trust does not qualify, then the income tax on the IRA must be paid within five years of the participant's death.
Conduit or Non-Conduit Trusts.Assuming that the trust meets the minimum tests mentioned above and the Trustee takes the RMD each year, the next question is how much the beneficiary is entitled to receive.
- If the trust requires that the trustee pay out the minimum required distributions to one designated beneficiary each year, it is considered a “conduit trust”, and the age of contingent beneficiaries will not be taken into consideration in determining the RMD.
- Sometimes it is not prudent to give the full RMD to a beneficiary. If the trust gives the trustee the discretion to pay the designated beneficiary or beneficiaries less than the RMD, then it is not a "conduit trust", and the ages of all contingent beneficiaries will be considered in determining the amount of the RMD. This means that the age of the oldest beneficiary who MIGHT receive payments from the IRA will be used to determine the RMD. In such trusts, it is common to include a clause saying that as to the IRA, only beneficiaries who are younger than the primary beneficiary can take if the primary beneficiary dies before the account is fully distributed.
Marital Deduction Planning.
It requires special planning to receive the marital deduction for an IRA that pays out installments to a surviving spouse.
It may be appropriate to designate your revocable trust as the beneficiary of an IRA if your beneficiaries are minors and you are not particularly concerned about implementing a stretch IRA. If you intended to have your IRA proceeds distributed to one or more charities, we usually recommend that the charities be designated as the beneficiaries and not a trust, except in special, exceptional circumstances.
1. If you are married and you want your spouse to have the IRA without restrictions, consider naming your spouse as the sole primary IRA beneficiary.
2. If you are married and you want your spouse to have the income or required minimum distribution (whichever is greater) from the IRA, then the beneficiary might be a QTIP (marital-deduction) trust that is coordinated with the IRS' requirements to qualify for the marital deduction when an IRA is involved.
3. If you are unmarried or you do not want your spouse to be the beneficiary:
A. If you want a "stretch" IRA and the intended beneficiaries are disciplined to take out only the required minimum distributions over their lifetime and have no significant risks for claims by creditors (including ex-spouses), then consider designating the intended beneficiaries by name.
B. If you want a "stretch" IRA but the beneficiaries might be tempted to take early withdrawals or may be vulnerable to creditors' claims, then consider naming as the IRA beneficiary a trust that is established as a qualified beneficiary that will provide for the trustee to take the required minimum distributions each year and distribute them in accordance with your wishes.
C. If a "stretch" IRA is not important to you, then it is probably best to name your revocable trust as the beneficiary of your IRA. The trust should contain alternative beneficiary designations and options that a normal beneficiary designation for an IRA would not contain.
D. If you are married and the IRA contains community property, designating a beneficiary who is not the participant's spouse will require the spouse's written consent.
4. If you are interested in the "stretch IRA" or marital deduction and you want to designate a trust as a beneficiary, your trust will probably have to be modified to obtain the desired results. Never assume that your trust has been designed to be a "qualified beneficiary" of an IRA without confirming it with the attorney who drafted the trust or some other qualified trust and estate attorney. Many trusts have contingent beneficiaries that may be older than your primary beneficiaries, and, unless the trust is drafted properly, the age of the older contingent beneficiaries will determine the life expectancy that is used to calculate the required minimum distributions, which would shorten the term of the trust and reduce the potential period during which income and growth could accumulate in a tax-free environment.
5. Unless you are willing to gamble as to the tax consequences, do not make a final decision regarding the designation of a beneficiary for your IRA without consulting with your certified public accountant and/or attorney.