When considering the manner in which beneficiary designations are set forth for tax-deferred retirement accounts (IRA’s, 401(k)s, and 403(b)s), several factors need to be considered; including simplicity, tax considerations, and beneficiary protections. This article may frequently refer to IRA accounts, but the core rules are the same for 401(k)s and 403(b)s.
Basic Concepts during the Owner’s Lifetime
To speak in broad generalities, if these tax-qualified retirement accounts are funded with “pre-tax” money, as in a traditional IRA, most people understand that the money can’t be taken out without penalty prior to age 59 1/2, and must start to be taken out no later than 70 1/2 with at least annual Required Minimum Distributions (RMDs) to the owner thereafter. The RMD is calculated based upon the balance in the account on December 31 of the preceding year, divided by your life expectancy under IRS tables (Publication 590). The older you get, the greater the percentage you must withdraw. In the meantime, the money grows tax-deferred. As it is distributed, it is taxed as ordinary income.
The Roth versions of these accounts remove the RMD requirement for the original account owner, so the money can continue to grow tax-deferred. Roth accounts can also be distributed tax-free so long as the rules are met (such as a minimum 5 years holding period, and distributions after age 59 1/2).
There are more subtleties to this discussion, but this is a sufficient backdrop for the focus of this article, which is how the accounts are handled after the original account owner dies.
Surviving Spouse as Beneficiary
If there is a surviving spouse of the original account owner named as beneficiary, he or she has two options. A surviving spouse can direct the account to be treated as a spousal rollover, or instead as an inherited account. A spousal rollover lets the surviving spouse treat the account as though it was their own account all along. This means it continues to be tax-deferred, can be accessed without penalty after 59 1/2, and RMDs must begin at 70 1/2. While this is the most common approach, it can present a problem for younger spouses who might need access to the money before 59 1/2.
In those cases, such as where a surviving spouse hasn’t hit 59 1/2, a spouse may desire to elect it as an inherited account, which can be accessed anytime without penalty (which is nice), but the account will be subject to annual RMDs each year after the account owner’s death, based on the surviving spouse’s life expectancy, whether the RMDs are needed or wanted (not as nice). There are also options to use the deceased spouse’s life expectancy in the calculation of an Inherited IRA instead, which may be helpful if the surviving spouse is older than the original account owner. Finally, if the IRA owner died prior to age 70 1/2, the surviving spouse can elect to take the entire balance out, at once or in pieces, at any time or times over the next five years, and pay income tax (if a Traditional account, not a Roth) upon those distributions. Using this alternative, after 5 years the money must all be taken, taxes due must be paid, and the tax-deferral stops.
Under any method, Traditional accounts are taxed as income when distributed, and Roth’s are generally free of income tax.
When the surviving spouse is not the beneficiary, the only option is an Inherited IRA. In these cases, the question of how the schedule for when RMDs must be taken from Traditional IRA accounts becomes a little more complex, depending on the beneficiary.
It is important to note that for even a Roth account, a non-spouse beneficiary must take at least annual RMDs based upon life expectancy or otherwise as discussed below. The Roth rule about “no RMD necessary” does not apply to Inherited Roth accounts.
An individual named as beneficiary, such as a child or sibling, can spread the RMDs out over his or her lifetime, using the same type of life-expectancy calculation as the original account owner would use, however, since the beneficiary is (usually) younger than the original owner, the RMD calculated is smaller. This means that the amount which remains growing tax-deferred remains larger for a longer period. This is often called the “stretch” of a retirement account.
The beneficiary can access the money more quickly if they desire, but no matter what else happens it has to be taken out no later than by the end of their life expectancy using the RMD calculation. If the beneficiary passes away after inheriting an IRA, the account will pass to his or her named beneficiaries, but the RMD calculation on any remaining balance will continue to be based upon the life expectancy table as though the original beneficiary hadn’t died. The RMD is not re-calculated to accommodate the age of the next new beneficiary.
As an alternative, if the original account owner died when younger than 70 1/2, the individual beneficiary can elect to take the entire balance out, at once or in pieces, at any time or times over the next five years, and pay income tax (if a Traditional account, not a Roth) upon those distributions. Using this alternative, after 5 years the money must all be taken, taxes due must be paid, and the tax-deferral stops.
If your beneficiary is your probate estate, or a charity, or a trust not designed to accommodate retirement accounts, the distribution rules are less flexible. Such beneficiaries are not considered qualifying “designated beneficiaries” for calculating a lifetime stretch. This makes sense, because these beneficiaries don’t have a “lifetime”. Such non-designated beneficiaries may continue the account owner’s RMD schedule if the account owner was required to take RMDs (i.e. over 70 1/2), or else they must use the option of taking the entire account out within 5 years and pay income tax (if a Traditional account, not a Roth) upon those distributions. As with individual beneficiaries using this 5-year alternative, after 5 years the money must all be taken, taxes due must be paid, and the tax-deferral stops. Note that there are some “fixes” which may be accomplished to mitigate these rules if an estate or trust is named when an intended individual beneficiary would be better served if they can get the “designated beneficiary” treatment, however it is better to get the designations correct initially.
Finally, if your beneficiary is a trust which is specifically drafted to accommodate retirement accounts, you can get the best of both worlds. A trust can qualify for the “stretch” treatment of the IRAs, permitting a lifetime of tax deferral. The question then becomes “Whose lifetime?”. If a trust can take the RMDs from the account and not give them to the ultimate trust beneficiary (i.e. it can accumulate the RMDs inside the trust from year to year), then the “lifetime” is that of the oldest possible trust beneficiary. Thus, if your children are the trust beneficiary, but upon their death it would go to their children, but if their children are all dead it would go to your brother, then your brother is the oldest potential beneficiary, and his life expectancy is used.
We instead often draft a trust which doesn’t “accumulate”, or hold the RMDs, but instead pays them as income to the beneficiary each year. This is sometimes called a “conduit” or “see-through” trust, because the trust passes the retirement account distributions annually to a beneficiary the IRS can predict, or “see”, and lets us then use that individual’s age for calculating the RMD schedule. In the example above (children, grandchildren, then brother), the life expectancy of your oldest child at your death would determine the available tax-deferral stretch and RMD schedule.
In many families with several children, the children are relatively close in age, and everyone is satisfied to use the age of the oldest of the children to calculate the RMD stretch. Sometimes, however, when the children are widely separated (such as a second marriage, or the “surprise” child), it is worth the extra effort to let each child use their own separate ages to calculate the RMD schedule. This can be achieved by a little more attention to the beneficiary designation, identifying each separate trust share of the children as a separate beneficiary.
For example, assume a trust is a “see-though” trust which pays the RMD to the children each year. The children are aged 50, 48 and 30 when their parent dies. The parent has named the trust as the primary beneficiary upon his or her death. The trust would ordinarily separate the account into three pieces for each of the children or their trust share, and each child would thereafter have their own account. Each account, however, would have to calculate annual RMDs based upon the age-at-death of the oldest child who was 50. That life expectancy is about 34 years according to the IRS, so each beneficiary has to take 1/34th out the first year after death, 1/33rd the second year, 1/32nd the third year, and so on. That schedule is set at the time of death. That schedule is fine for the older children, but the 30 year old has an IRS life expectancy of 53 years. Instead of having an RMD of 1/34th, they might want to reduce the RMD (and lengthen the period of available stretch) so that they only have to take 1/53rd the first year, 1/52nd the second, etc. To achieve this goal, we modify the IRA beneficiary designation from just “The Smith Trust dated 1/1/2015” to reflect instead “1/3 to Child A’s Separate Share of the Smith Trust dated 1/1/2015, 1/3 to Child B’s Separate Share of the Smith Trust dated 1/1/2015, and 1/3 to Child C’s Separate Share of the Smith Trust dated 1/1/2015.” Now there are three separate beneficiaries of the IRA, and each trust share can use its beneficiary’s age to set the stretch.
So Why Name A Trust as Beneficiary?
While naming a trust or trust shares as beneficiary requires a little more work up front, it can provide significant protection to the beneficiaries from a variety of risks, such as;
Legal Capacity: If you name a minor as a beneficiary, or if your beneficiary dies and the account passes from them to a minor, that child can’t take title to property. Instead, a Guardian may need to be appointed by the court to oversee the asset until the child attains age 18, at which time the youngster has complete access to spend the money any way she desires.
Creditors: While your retirement accounts are very secure against creditors for you and your spouse under federal and most state laws, the rules change when these accounts become inherited accounts. The U.S. Supreme Court ruled in 2015 that such assets are not entitled to the asset protection given to “retirement funds” under federal law. Thus, they are exposed to any current or future claims against the beneficiary, such as debts, liens, lawsuit judgments, foreclosure deficiencies, bankruptcy, etc. If a trust is designed to protect a beneficiary against such risks, then it makes sense to wrap this protection around the retirement assets as well.
Long Term Care: If a beneficiary has an inherited retirement account, he will usually be ineligible for government assistance with long-term nursing care stays until that account is entirely depleted. A trust can be designed to shelter this account, taking it “off the books” for consideration by the government in applications for such benefits so that the money stays with the family to cover needs for which the government won’t provide.
Children with Special Needs: If a member of the family has a disability which permits them to obtain government benefits, receipt of an inheritance outside of a proper trust, including inherited retirement accounts, can disqualify them from their important benefits.
Imprudence: Individuals who inherit retirement accounts can do whatever they want with the funds. We see inexperienced beneficiaries spending the money too quickly, rather than saving it for their future security. Even worse, many an inattentive beneficiary has elected to have the entire account distributed to them following a death, and they are very surprised by the large income tax bill they face on the entire account the following April 15th. Often, they no longer have funds available to pay the tax at that time, and problems ensue. If we create a trust to protect a beneficiary from his own financial inexperience, whether for just a while or for their entire lifetime, it often makes sense to include the retirement assets within the scope of this protection.
In a nutshell, if you are protecting family members with a trust after your death, if often makes sense to take the little extra effort to extend this protection to the retirement assets they will obtain as well.
Income Taxation of Retirement Accounts in Trusts
The distributions from inherited Traditional retirement accounts are treated as income, and are income tax-free when they come from Roth retirement accounts. Some questions emerge about how taxation may be different with a trust involved. Provided that the trust income, including the retirement account distributions, is being paid to the trust beneficiary, the trust itself has no tax liability. Instead the trust is merely a conduit, and just the income (including payments from retirement accounts) ends up on the beneficiary’s tax return. In these usual cases, the trust files an informational Form 1041 to tell the IRS what the beneficiary received, so that the IRS knows where to look for that income. The beneficiary receives a K-1 to tell them what income to report on their own return.
In some cases, however, we don’t want the income going right to the beneficiary. What if they are being hounded by creditors, or applying for governmental benefits, and that income would just be subject to claims from such outsiders? In those cases, the selected Trustee of the trust might elect to retain the income inside of the trust instead, in order to provide further protection. In such cases, the IRS then considers the income to be taxable to the trust, and the trust pays tax on the income. Trusts with retained income are subject to a similar “tiered” income tax rate structure, but the tiers are compressed.
For example, a single individual sees their income tax rates increase from 10% to 39.5% as their income increase in tiers (roughly, 15% marginal rate at $9,000; 25% marginal rate at $37,000, 28% marginal rate at $89,000, 33% marginal rate at 186,000, and the maximum 39.5% rate after $406,000). A trust with retained income hits the 25% marginal rate at only $2,500, 28% at 5,800, 33% at $8,900, and hits the maximum 39.6% rate at $12,500. Thus, the same rates are used, but smaller amounts cushion between tiers. For this reason, income is usually paid to the beneficiary, because it will see lower tax rates. When a beneficiary is in jeopardy, however, it is often better to pay a bit more in taxes and have the remaining income be protected than to distribute the income to the beneficiary to save taxes but then lose the balance to a creditor. Many trust designs give us flexibility to pass income when appropriate, and retain income (and pay tax through the trust) when necessary.
Notably, to the extent income is retained in the trust (and taxes paid), it is added to principal, and when thereafter distributed at an appropriate time, it is not again taxed.
The question of how to designate the beneficiaries, both primary and contingent, on your tax-qualified retirement accounts clearly requires you to weigh and balance a number of factors, including simplicity, taxes and protection. Please consult with your financial, tax and/or legal counsel for specific guidance regarding how these strategies should be employed in your unique case, because everyone has his or her own set of needs, goals and circumstances.
If you would like more information regarding these issues, please feel free to contact us for a complimentary consultation.
Note: the information included above is obviously general in nature, and should not be relied upon by any individual or entity for their specific circumstances. Contact us or another attorney or professional advisor for advice regarding your unique situation .