Retirement Standard Beneficiary Review

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1 beneficiary review 2 What are the benefits of consolidating my retirement accounts? 2 What should guide my decision about beneficiaries? 2 When should I designate my spouse as my primary beneficiary? 3 Which assets should I consider leaving to charity? Retirement Standard Beneficiary Review summary How can I maximize the benefits of my retirement accounts for myself and my heirs? Your individual retirement account(s) (IRAs) and qualified retirement plan account(s) are designed to provide you with retirement income, but they can also be a powerful way to pass assets to your heirs or philanthropic interests. Steps you take now could dramatically reduce the taxes your estate and/or your heirs will pay in the future. The choices your heirs make at the time of inheritance also need to be carefully planned so your wealth will keep working for the next generation. This brief can help you identify and address some common issues that can lead to the comfortable retirement you envision. Retirement Standard Checklist: Lifestyle Review Family Records Organizer Beneficiary Review Retirement Account Assessment Your Retirement Income Plan Risk Review Pension Election Social Security Benefits Health Care Cost Evaluation Retirement Goal Analysis

2 beneficiary review Q. What first steps will help maximize the benefit of my retirement accounts? A. Good planning is the key to managing and investing current funds effectively and maximizing future funds for heirs. Here are some basic steps to get you started: To the extent possible, consolidate scattered retirement accounts (IRAs, 401(k)s, pensions) so you have a concentrated picture of your retirement savings and how it s invested. Identify the named beneficiaries on your retirement accounts and ensure they are still the ones you want. Note that your beneficiary designation forms not your will determines who inherits your retirement accounts. Determine whether or not you want to name a charity or a trust as your retirement account beneficiary. Review your retirement account or accounts on a regular basis. Q. What are the benefits of consolidating my retirement accounts? A. If you maintain a hodgepodge of accounts, you may be driving up your investment and maintenance costs, reducing the effectiveness of your asset allocation and making financial planning more difficult not to mention incurring a steady blizzard of account forms, statements and other records. Consolidating your retirement accounts can simplify your life and give you a clear and accurate picture of what you own. You may discover that having several accounts results in investment overlap, wherein you actually own more of the same investments or types of investments than you realized, thus increasing your risk. In addition, consolidating accounts makes it easier to keep track of and change beneficiary designations should a life changing event occur. Q. Why are beneficiary designations so important? A. The amounts you have in your retirement accounts pass directly to your beneficiaries upon your death. Unlike assets covered in your will, the process is not subject to probate and the beneficiary designation takes precedence over the terms of your will. Suppose you designated your first husband as the beneficiary of your IRA. If you remarry and do not change the designation, your first husband may inherit these assets regardless of the terms of your will. Q. What should guide my decision about beneficiaries? A. Choosing an appropriate beneficiary may be affected by legal, emotional or tax issues or some combination of all three. Significant life changes such as marriage, children, divorce or death can all impact your choice of beneficiaries. As noted above, out-of-date beneficiary forms could result in former spouses inheriting retirement accounts meant to support a current family. If children are involved, survivors might be left wondering why one set of children inherited all the retirement assets, while the others were left with nothing. If your beneficiary predeceases you and you named no secondary or contingent beneficiaries, your retirement account assets may go to someone you didn t expect would inherit them. Q. How often should I review beneficiaries? A. It makes sense to review beneficiaries at least once a year to be sure your retirement assets will pass to the person, group or organization of your choosing. Q. When should I designate my spouse as my primary beneficiary? A. Naming your spouse as your beneficiary makes sense if your spouse will need your retirement account funds for lifetime financial support. A spouse can roll your account assets into an existing or fresh start IRA. The process can be somewhat complex but if done correctly, your spouse can avoid paying current income and estate taxes on the transfer. Your spouse will then have the opportunity to name a child or other 2 morgan stanley 2012

3 beneficiary, which may allow the IRA to stretch payouts and continue growing tax free over the lifetime of that second beneficiary. Surviving spouses should consult their tax and legal advisors as to whether an existing or fresh start IRA, as opposed to an inherited IRA, is the right option. Before you automatically name your spouse as your retirement account beneficiary, speak with your Financial Advisor and tax and legal advisors about how it could affect your family s overall tax burden or your long-term estate plans. Q. If I choose a minor child as my beneficiary, how will they be able to take care of their inheritance? A. There are at least three choices for properly designating a minor beneficiary of your retirement account: 1) a legal guardian can be appointed for the minor; 2) you can create a trust for the benefit of the minor that meets the IRS requirements for stretching out payments over the minor s life expectancy; or 3) you can name a custodian under the Uniform Transfers to Minors Act (UTMA) to receive the retirement account on behalf of and for the benefit of the minor until the minor is 21 years old. You should consult with an estate planning attorney before choosing which alternative is right for you. Q. What happens when a nonspouse is my beneficiary? A. If you are not married, or if you simply choose to leave your retirement account to someone other than your spouse, you may designate one or more nonspouse beneficiaries. In some states with community property laws, your spouse may have to consent in writing if such a designation is made with respect to an IRA (this is discussed in more detail below). Leaving your retirement account to a Not All Bequests Are Equal Consider leaving your IRA to charity and your taxable portfolio to your heirs. Because of the step-up in the cost basis of the inherited securities, a taxable portfolio may be more valuable to an heir than an IRA, whereas either a taxable account or an IRA would yield the same 100% net bequest to the charity. IRA much younger person can be an effective way of deferring or even reducing your family s tax liability. That person may keep your retirement account as a tax-deferred investment vehicle and take lifetime distributions. This avoids the tax hit that would occur if the inherited account were distributed in a lump sum, and it can preserve the taxdeferred status of the assets. Q. Which assets should I consider leaving to charity? A. If you are planning to make a charitable bequest, it might make sense to leave appreciated securities which are not in a tax-qualified vehicle to your heirs and donate your traditional IRA or qualified retirement plan account to a qualified nonprofit charity, as the charity is not To Your Heir To Your Charity IRA Value at Death $100,000 $100,000 Ordinary Income Tax Rate 35% 0% Net Bequest $65,000 $100,000 Taxable Portfolio Assets Taxable Assets at Death $100,000 $100,000 Original Cost Basis $20,000 $20,000 Capital Gains Tax (when sold at death) 0 0 Net Bequest $100,000 $100,000 subject to income taxes when the assets are distributed. However, leaving your Roth IRA funds to a charity or other entity would fail to take advantage of the benefit that leaves your Roth IRA free of income tax. Also, when heirs inherit certain taxable assets such as common stocks, equity mutual funds, business interests and real estate, they get a step-up in the original cost basis to current fair-market value. That effectively removes any income tax liability at the time of inheritance and dramatically reduces the capital gains tax heirs will have to pay when they eventually sell the inherited assets. In contrast, heirs must generally pay income tax on the current market value of traditional IRA and qualified retirement plan account assets as amounts are withdrawn. morgan stanley

4 beneficiary review Trusts as Beneficiaries Trusts can be an integral part of an individual s estate plan. Properly used, trusts may protect beneficiaries from creditors or potential future former spouses. Additionally, trusts can be used to help manage property for beneficiaries who are not capable of managing the assets on their own, and they can provide support for one beneficiary while protecting a portion of the trust for other beneficiaries. Before a trust can be considered a designated beneficiary for the purposes of the Internal Revenue Code s minimum distribution requirements, all of the following requirements must be met: The trust must be valid under state law. The beneficiaries must be identifiable from the trust document. The trust must be irrevocable or become irrevocable upon the death of the retirement account owner. A copy of certain documentation must be provided to the plan administrator (in the case of an IRA, the IRA trustee, custodian or issuer) within a certain timeframe, in accordance with the requirements of the Internal Revenue Code. If all of these requirements are met, the trust is considered a designated beneficiary of the retirement account. The trust beneficiaries are then eligible to stretch their required minimum distributions out over the life expectancy of the eldest trust beneficiary (if individual trusts are created for each beneficiary, the life expectancies can potentially be calculated on each individual beneficiary s life expectancy). Keep in mind that, under the trust, naming a beneficiary which is not an individual may negatively impact the ability to stretch required minimum distributions over the life expectancy of the eldest trust beneficiary please consult your tax and legal advisors. If any of these requirements are not met, and subject to the terms of the involved retirement account s governing documentation, the trust would usually not be considered a designated beneficiary and distributions would be subject to the five-year rule meaning the account would need to be distributed by the end of the fifth year after the account owner s death if the account owner was under 70 ½ at the time of death. If the account owner was over 70 ½, the distributions would (again, subject to the account s governing documentation) usually be based on the remaining distribution period of the deceased account owner and not on the beneficiary s life expectancy. 4 morgan stanley 2012

5 Qualified Terminable Interest Property (QTIP) Trust. A Qualified Terminable Interest Property (QTIP) trust may be advisable when the account owner wants an IRA to provide for a surviving spouse during his / her lifetime but also wants to retain the ability to determine who will be the ultimate beneficiary of the IRA. The surviving spouse may be entitled to receive the greater of the investment income or required minimum distribution at least annually. A QTIP trust is often used in second marriage situations where the account owner has children from a previous marriage. One disadvantage of using this type of trust is that the required minimum distributions for the remainder beneficiaries are not based upon their own life expectancies but rather that of the oldest beneficiary, who may be the surviving spouse. Another disadvantage is that the remainder beneficiaries cannot receive any distributions from the QTIP trust until the surviving spouse passes away. Charitable Remainder Trust. If an IRA account owner wants to provide for family members and ultimately for charity, a charitable remainder trust (CRT) is something to consider. A CRT is a split-interest trust whereby an individual or individuals will receive a payout from the trust for life or for a term of years not to exceed 20. At the end of the term, the remainder of the trust will pass to the charitable beneficiary or beneficiaries. When setting up the CRT, the beneficiaries must be entitled to a payout of at least 5% per year and the actuarial value of the charity s interest must be at least 10% of the initial value of the trust. When the CRT receives the lump sum from the IRA, it will not be subject to any immediate taxation. One of the advantages of using the CRT as an IRA beneficiary is that, while distributions from an IRA would normally be taxed at ordinary income tax rates, some of the distributions could potentially be taxed at capital gains tax rates. One downside is that if the beneficiary had Types of Trusts 1 2 a stretch IRA, the beneficiary could take out more than the required minimum distribution; however, when naming a CRT, the beneficiary cannot receive more than the payout specified at the time the trust was created. Disclaiming Sometimes a named beneficiary will not want to accept the retirement account assets for a number of reasons and want them to pass to someone else. This can potentially be accomplished when the beneficiary makes something known as a qualified disclaimer. A qualified disclaimer must be irrevocable, in writing, compliant with applicable law and made within nine months of the account owner s death, Qualified Terminable Interest Property (QTIP) Trust Charitable Remainder Trust and the beneficiary must not have accepted the benefits or directed where they are going. If these requirements are met, the disclaimer will be valid and the assets will pass without any tax consequence to the disclaiming party. Unfortunately, if any of these conditions are not met the disclaimer will not be qualified and could potentially lead to the imposition of a gift tax on the transfer to the disclaiming party. Often, the area that causes the disqualification is the nine-month limit to accomplish the disclaimer or an attempt to direct where the disclaimed assets will go. It is important to work with your attorney to have the disclaimer properly and timely drafted. morgan stanley

6 beneficiary review Common Errors Spousal Consent. Many individuals are confused as to whether or not spousal consent is required where the account owner is not leaving 100% of their IRA to their spouse. The confusion stems from the fact that under the Employee Retirement Income Security Act (ERISA), a qualified retirement plan always requires spousal consent when the spouse is not named 100% beneficiary of the retirement plan assets. With IRAs, state law determines whether or not spousal consent is required. If you reside or have resided in one of 10 states (Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin), your IRA (or a portion of it) may be considered community property. In those states, in order for an account owner to leave their IRA to someone other than a surviving spouse, spousal consent may be required. The remaining states follow the separate property system, and in those states spousal consent is not required. Designations That Dictate Who Receives Assets Upon a Beneficiary s Death. Another common mistake is creating a beneficiary designation where the account owner wishes to dictate who the remainder beneficiary of the retirement account will be without naming a trust as the beneficiary. For example, I leave my retirement account to my son and if my son does not distribute the retirement account while he is alive the remainder of the retirement account shall pass to my daughter. This beneficiary form is generally not enforceable because once the son inherits the retirement account outright, the father no longer has any right to dictate who will receive the retirement account upon the son s death. The designation would usually not be acceptable and, upon the death of the account owner, the default provisions of the service provider could apply. Estate as Beneficiary. If the account owner chooses an individual or individuals as beneficiaries, the beneficiaries can usually stretch out the distributions from the retirement account over their lifetime. If the estate is the named beneficiary and the account owner is under 70 ½, subject to the terms of the involved retirement account s governing documentation, the distributions usually must come out of the account pursuant to the fiveyear rule meaning the account must be distributed by the end of the fifth year after the account owner s death. If the estate is the named beneficiary and the account owner is over 70 ½, the distributions are (again, subject to the account s governing documentation) usually made based on the remaining distribution period of the deceased account owner, not on the beneficiary s life expectancy. Another concern with naming an estate as a retirement account beneficiary is that it can subject the retirement account to the probate process. If an individual, trust or charity is named as a beneficiary, the retirement account is not subject to the probate process and passes by operation of law pursuant to the terms of the beneficiary designation form. In a nutshell, naming an estate as beneficiary will potentially accelerate the income tax liability and convert a nonprobate asset into a probate asset. Absolute Dollar Amounts. Most clients divide their retirement account using a percentage basis. Some clients, however, have an interest in dividing their account by absolute dollar amounts. Most service providers will not accept beneficiary designations that specify an absolute dollar amount. The fear is that, while alive, the account owner may decide to take larger distributions from the account than planned when the initial beneficiary designation was made and the account may not have enough funds remaining to meet the absolute amounts stated for the beneficiaries. You should contact your service provider to discuss what absolute dollar designation options may be available to you. 6 morgan stanley 2012

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8 The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their tax or legal advisors before establishing a retirement plan and to understand the tax, ERISA and related consequences of any investments made under such plan Morgan Stanley Smith Barney LLC. Member SIPC. WP CRC / /12