Too often an overlooked yet important element of your estate plan is your 401(k) and IRA beneficiary designations. Financial planners deem these “matter of fact” designations while overlooking their legal and tax consequence, and many lawyers aren’t skilled enough in the retirement arena’s tax laws to raise issues clients should consider.
The current generation of retirees and soon-to-be retirees has a greater percentage of their net worth in IRA and 401(k) accounts than any previous generation. Hence, these accounts become that much more critical to the success of your estate plan, and the well-being of your beneficiaries.
For married couples, naming a spouse seems easy enough, for example. In first marriages where the spouse is also the parent of the couple’s children, it’s not unusual to name that spouse as the primary beneficiary. Spouse rolls over the IRA making her the new owner. She can designate whomever she wants as her beneficiaries, and in all likelihood, it will be the children of that marriage.
As I’ve pointed out in previous columns and white papers, when there’s a blended family, the legal and tax issues aren’t so clear, and should be carefully thought out. Naming a second spouse who is not the parent of your children as your primary beneficiary could result in disinheriting your children. For my thorough discussion on this topic, go to https://www.floridaestateplanning.com/blendedira
Naming one’s revocable trust as a primary beneficiary has become common. This is a minefield for the unwary, and as I point out, unless your financial planner or estate planning lawyer is skilled in this very specific area of the law, he might lead you astray.
For a beneficiary of your revocable trust to be considered the beneficiary of your IRA for distribution purposes, the trust must meet five specific criteria known as the “identifiable beneficiary” rules. Failure to satisfy all five of those rules often results in the acceleration of taxable income over 5 years as opposed to ten years for most beneficiaries, or what might be an even longer distribution period if that beneficiary is your spouse, 10 years or less younger than you, your minor child or disabled.
In other words, failing to satisfy the identifiable beneficiary rules results in the payment of more income taxes sooner, with less tax deferred growth than would otherwise be available to your loved ones. I can best illustrate this by example:
John owns an IRA account naming his revocable living trust as the beneficiary. His revocable living trust names his wife Jane as the primary income beneficiary for her lifetime, then John’s children as the remainder beneficiary after Jane’s death. Because John’s revocable trust has standard provisions about paying taxes, expenses of administration and creditors (which are also required by law), Jane does not qualify as an identifiable beneficiary, since IRA proceeds might be used to pay creditors, taxes or expenses of administration. Consequently, rather than a lifetime payout to Jane, the five-year payout rule applies.
Assume instead that John names the specific trust share inside of his IRA for Jane as the beneficiary to his IRA. The designation looks something like this:
“The Marital Trust share for Jane under John’s Revocable Trust dated January 3, 2021.” Assume further that if Jane doesn’t survive John, the marital trust divides into three different shares, one each for John’s two children and another to charity.
John’s beneficiary designation now avoids the trap mentioned above that the IRA proceeds can’t be used to pay taxes, creditors or expenses of administration. He has designated Jane’s trust share specifically (and let’s further assume the language of the trust prohibits the payment of taxes, expenses and administration costs from IRA distributions).
Alas, even with all that good drafting, the five-year distribution rule still applies. Why? Because rule #3 requires that all designated beneficiaries must be eligible individuals. If Jane predeceases John, a charity will become a 1/3 beneficiary of the trust share established for Jane. A charity is not an individual. Whether or not Jane survives John is irrelevant. The five-year distribution rule applies.
How about a share that does qualify as identifiable, yet traps the income inside of the trust share? Assume that John names a trust share for his son, Gary. Gary has a ten-year payout under the SECURE Act distribution rules. Assume in the second year following John’s death, Gary withdraws $100,000 from his inherited IRA account, but doesn’t distribute the full amount from the trust checking account into his own account.
Irrevocable trusts pay a higher marginal income tax rate than would an individual. Under current law, the trust is the taxpayer to the undistributed funds and pays a 37% marginal rate on taxable income accumulated over $13,050. Gary, as a married filing jointly taxpayer, doesn’t pay that marginal rate until he and his wife have over $622,000 of taxable income.
Why might Gary accumulate rather than distribute the income? Assume Gary is trying to protect it from a judgment creditor. Gary might practice in a high-risk profession or be sued in a business deal gone bad. There might be any number of reasons.
I could go on and on with other examples, and I haven’t interplayed the gift and estate tax laws yet, among other issues. This is a complex area of the law that will have real economic effect on your loved ones.
Hopefully you now understand how significant IRA and 401(k) account beneficiary designations are to your estate plan. Don’t be complacent with your choices. Have a well-qualified attorney in your corner and consider all options.
2021 Craig R. Hersch learn more at floridaestateplanning.com
