Is your estate plan on speaking terms with your retirement plans?
By Christopher J. Godfrey, Esq.
Our estate plan often has little control over our largest asset.
When you set up your IRA, how did you decide on a beneficiary? Conventional wisdom tends to focus on only two things: “What will be the income tax impact after the IRA participant dies?” and “You should NOT name a trust as an IRA beneficiary.”
There is a misconception that naming a trust as a beneficiary must force all IRA assets to be paid out in five years. It is also believed that in naming a trust, a surviving spouse loses the opportunity to do a rollover. Minimizing and avoiding taxes is an important aspect of estate planning. But if we only consider taxation, what other planning opportunities do we miss?
Many people express a strong desire to protect what they leave their loved ones from future mishaps. Married people are often concerned that if their spouse remarries after their death – the inheritance may go to some other family in the future. They may also want to protect their surviving spouse from a Medicaid spend-down. And what about beneficiaries other than a surviving spouse such as minor children - who will manage the assets for them?
Although a surviving spouse named as an IRA beneficiary can rollover the deceased spouse’s IRA to their own and defer taxable distributions until they reach the age of 70 ½, this good tax result may come at the expense of protecting against life’s risks.
Most people (when asked) would like to protect their loved one’s assets indefinitely from possible lawsuits, failed marriages, poor life decisions, or mental incapacity. A properly drafted trust can provide this protection as well as meaningful instructions for its use, while not completely cutting off their beneficiary’s access and control over the property.
The good news is that we don’t need to choose between taxes and protections right now. There is a way to build flexibility into our estate and retirement plans that allows us to maximize the advantages of both later on.
After death distributions from a retirement plan are taxable income to the beneficiary. It makes sense to defer distributions (thereby the tax) as long as possible. How quickly (or slowly) a retirement plan must be distributed depends on two things; the plan participant’s age at death, and whether the beneficiary is a spouse, a “designated beneficiary”, or something else.
A surviving spouse beneficiary has the most preferred treatment, they may “roll over” retirement plan funds to their own IRA, and defer distributions until they turn 70½. Only a surviving spouse may do a roll over.
Generally, a beneficiary who is not a surviving spouse or a “designated beneficiary” must take the money out of the retirement plan within 5 years of the participant’s death if the plan participant dies before they turn 70 ½, or over the remaining life expectancy of the plan participant if he or she dies after 70 ½. A “designated beneficiary” may not roll over an IRA, but may take distributions over his or her life expectancy (commonly called “stretch-out”), based on tables published by the IRS.
A trust cannot be a “designated beneficiary.” But if it meets IRS regulations, the beneficiaries of this “qualified” trust will be treated as “designated beneficiaries” and not lose the stretch-out opportunity to defer taxes. So it is important that your trust will qualify if you are going to depend upon it.
How can our heir choose between a trust and an individual as our IRA beneficiary after we are gone? - by using disclaimers. A disclaimer is a “legal no thank you.” If a beneficiary disclaims, it is as if the beneficiary died first, and the property goes to the next in line, or contingent beneficiary. A disclaiming beneficiary must act within nine months; they cannot say who gets the disclaimed property, nor can they disclaim once they have taken possession of the property.
Here is how the strategy works with an IRA. An IRA participant could name a trust as primary beneficiary and an individual as a contingent beneficiary (or vice versa). When the IRA participant dies, the trustees of the trust can decide to either have the IRA in the trust, or disclaim and have it go to the contingent beneficiary.
There is a natural inclination to name the participant’s spouse as the IRA beneficiary and to simply “rollover” the deceased spouse’s IRA to their own. There are two reasons why this conventional wisdom might not be best. The first reason is practical. It is simply too easy for the surviving spouse to sign paperwork for the roll over before discussing alternatives with his or her advisor. Once this happens, the opportunity to disclaim is lost. If a trust is named, it will take meetings with the trustees and advisors to complete the disclaimer.
The legal reason for avoiding naming the spouse as primary beneficiary is that if a beneficiary disclaims property which later goes into a trust for the beneficiary, the beneficiary cannot have a power of appointment over the trust. A power of appointment is a beneficiary’s ability to say who gets the trust after the beneficiary’s death and under what terms and conditions. Many people appreciate this flexibility because it gives their spouse the ability to adjust to life’s events after they are gone.
Similarly, a beneficiary is inclined to take immediate possession of an inheritance and to spend it. If that happens all of the planning Mom and Dad have done with their team of financial and tax planners is lost. Naming a trust as primary beneficiary helps assure continuity of planning over the generations. Then, if a beneficiary is committed to receiving IRA money outright after receiving advice and counsel, your trustee can make that happen.
All of it depends upon the drafting of your estate plan, its coordination with your retirement plans, and maintaining them with trusted advisors.