Designating Trusts as Beneficiaries of Your Retirement Accounts. by Caitlyn K. Walters, Attorney at Law

Transcription

1 Designating Trusts as Beneficiaries of Your Retirement Accounts by Caitlyn K. Walters, Attorney at Law

2 If you have been told that you should never name a trust as the beneficiary of your retirement accounts, you are not alone. Many people have this misconception. Unfortunately, as a result, retirement account owners are missing out on the benefits that trusts have to offer as beneficiaries of retirement accounts in certain situations. Indeed, in some cases, naming a trust as beneficiary could be more advantageous than naming your spouse or your child directly. BACKGROUND ON RETIREMENT ACCOUNTS While your retirement accounts can be a very important part of your estate planning, they were never intended to be a method of transferring wealth to your family after your death. While it is true that, with the correct planning, your retirement account can provide for your family long after you are gone, Congress purpose for implementing certain benefits into our retirement system i.e., tax-free growth was actually to incentivize people to save money during their younger years to be used to support themselves in their later years. Thus, account owners are required to begin taking annual distributions from their retirement accounts at a certain age typically 70.5 years old and will be penalized if these distributions are not taken. Since Congress intended this money to be spent during the account owner s lifetime, incorporating these accounts into your estate plan in order to maximize its ability to care for your family after your death can be complicated. But it can be done. However, it is this complexity that has likely led to the misconception that trusts cannot be named as a beneficiary of your retirement account. While it is true that many times it is advisable, and easier, to directly name your spouse or child as the beneficiary, when drafted correctly, naming a trust of which your spouse and/or child is a beneficiary can provide the same benefits as well as the additional protections discussed below. 1

3 DESIGNATING INDIVIDUAL BENEFICIARIES Naming Your Spouse as Beneficiary Many people believe that it is best to directly name their spouse as the beneficiary of their retirement accounts because, in many cases, upon their death their spouse can rollover the account into their own. This rollover would allow the spouse to delay taking the required minimum distributions until she was 70.5 years old and then upon her death, whoever inherited the account could stretch out the distributions over their own life expectancy. For example, Paul names his wife, Mary, as the beneficiary of his IRA. Paul dies when Mary is 60 years old. Mary can rollover Paul s IRA into her own IRA and delay taking any distributions for 10.5 more years. Mary dies when she is 80, leaving her IRA to their son, John, who is 50 years old. John will be able to stretch out the distributions over his own life expectancy. This will allow the account to continue to grow tax-free and John can spread out the income tax payments over a longer period of time. While this sounds like a win-win situation, there are a few downsides to this method. First, only a spouse is permitted to rollover a decedent s retirement account. In the example, had Paul named John as the beneficiary instead of Mary, John would not have been permitted to delay taking distributions until he was 70.5 years old. Instead, he would have been required to begin taking distributions in the year after the year of Paul s death. Furthermore, when your spouse is named as the beneficiary of your retirement account, it becomes hers upon your death, leaving you without a say as to who should receive your retirement account upon her death. In the example, if Paul named Mary as the beneficiary of his retirement account, Mary could decide to leave the entire account to her second husband upon her death. John, whom Paul most likely would have preferred to receive his money over Mary s new husband, would not receive anything. 2

4 Naming Your Child as Beneficiary In order to avoid the possibility that their children will not receive their retirement account upon their spouse s death, some people directly name their child as the beneficiary of their account instead of their spouse. For example, Paul designates John as the beneficiary of his IRA instead of Mary to ensure that John will receive this money upon Paul s death. John will not be able to rollover this IRA into his own IRA, but he will be able to stretch out the distributions over his life expectancy. However, there is also a potential downfall to naming your child as the beneficiary of your retirement accounts. Your child s option to stretch out the distributions over their life expectancy is just that an option. They are not required to leave your retirement account intact and instead, may withdraw all of the funds at once. While an older adult child may be able to be trusted to make an educated decision regarding his options, a child of only 18 may not be able to be so trusted. For example, if Paul designated John as the beneficiary of his IRA and Paul died when John was 18 years old, John may be tempted to drain the account immediately in order to buy the latest expensive car on the market. He may not be old enough to understand the advantages of leaving the money in an account to grow tax-free. DESIGNATING TRUST BENEFICIARIES While naming a trust as the beneficiary of your retirement account does have its problems, they are not insurmountable. In fact, once these issues are overcome, having a trust as the beneficiary of your accounts and naming your spouse and/or children as beneficiaries of the trust - can yield a much more preferable result than naming an individual. Naming a Trust as Beneficiary Instead of Your Spouse As discussed above, there can be problems with naming your spouse as the beneficiary of your retirement account. Many of these issues can be prevented by naming a trust as beneficiary instead. For example, particularly in second-marriage 3

5 situations, if you would like to avoid the possibility that your spouse will leave the account to someone other than your children upon her death, you will want to consider naming a trust - the beneficiary of which is your spouse - as the beneficiary of your retirement account. This situation would look like the following: Mary is Paul s second wife and John is Paul s child from his first marriage. Paul creates a trust naming Mary as the beneficiary and John as the remainder beneficiary. Paul then names this trust as the beneficiary of his IRA. Upon Paul s death, the trust will receive distributions from the retirement account and then the trust can distribute those payments to Mary. Because Paul has stipulated in the trust document that John will receive the trust assets after Mary s death, and because the distributions from the retirement account are trust assets, Paul can be sure that John will receive his retirement account distributions upon Mary s death. By naming the trust as the beneficiary, Mary does not become the owner of the retirement account and therefore cannot name a different beneficiary to receive the funds upon her death. Even if Mary were to remarry, she would have no authority to leave Paul s retirement account to her new husband instead of John. Furthermore, you may want to consider naming a trust as the beneficiary of your retirement account if you wish to maximize your estate tax exemption upon your death. When you die, in Maryland you are entitled to leave up to $1 million to your family estate-tax free. (NOTE: Currently the federal government allows you to leave up to $5 million estate-tax free, but this number will drop to $1 million on January 1, 2013, unless Congress acts before then). This is a per-person deduction that must be used at the time of your death. Therefore, each spouse can leave $1 million for a total of $2 million to their children estate-tax-free. However, if you leave everything outright to your spouse, who will already inherit everything estate-tax-free because of the unlimited marital deduction, you have wasted your $1 million coupon. Instead, if you leave $1 million in trust for your spouse to use during her lifetime, but which will ultimately go to your children upon her death, you can save them a significant amount of money in estate taxes. For many people, most of this $1 million used to fund the trust must come from life insurance and retirement benefits, making it advisable to name a trust as the beneficiary of their retirement account than to name their spouse outright. For example, in his estate planning 4

6 documents, Paul establishes a credit shelter trust that will be funded with $1 million at his death so that he can minimize the estate taxes John will have to pay upon Mary s death. The trust states that Mary will be able to use the assets in the trust during her lifetime, but that at Mary s death, John will be the beneficiary of the trust. The only money Paul will have to put into this trust upon his death is a bank account of $50,000 and a life insurance policy of $550,000. However, he also has $400,000 in his IRA. By naming the trust as the beneficiary of the retirement account instead of Mary, Paul can ensure that a full $1 million will pass to John estate-tax-free at Mary s death. NOTE: If it is unclear whether you will need to use your retirement account to fund such a credit shelter trust at your death (i.e., you are unsure whether you will have $1 million in other assets that can fund the trust), you can name your spouse as the primary beneficiary of your retirement account and name the credit shelter trust as the contingent beneficiary. This way, if the retirement account is not needed to fund the trust upon your death, your spouse can rollover the account into her name and take advantage of those benefits. But, if it is needed to fund the credit shelter trust, your spouse can disclaim the retirement account, effectively making the trust the beneficiary of the account and ensuring that you have maximized your estate tax deduction. Naming a Trust as Beneficiary Instead of Your Child As discussed above, there are potential downfalls to directly naming your child as the beneficiary of your retirement account. Many of these problems can be resolved by naming a trust, established for the benefit of your child, as the beneficiary of your account instead. One major problem with designating your child as your retirement account beneficiary arises if your child is a minor. Under the law, minor children cannot own property. Therefore, a guardian must be designated to manage their property for them until they reach the age of 18 at which point the guardian will be required to hand over all property to the child to manage on their own. Depending on the situation, the court may need to select someone as the child s guardian. However, by designating the trust as the beneficiary of the retirement account, you will be able to name a trustee of the trust who will be responsible for managing your child s 5

7 money, including the distributions from the retirement account, for their benefit until they reach whatever age you indicate within the trust document. Even if your child is not a minor, designating a trust as the beneficiary of your retirement account can protect your child from himself, his spouse, and his creditors in a way that directly designating your child cannot. By naming the trust as beneficiary, you can be sure that your child does not receive full control over the money at the age of 18 - you can designate any age that you want thus, ensuring that your child does not withdraw the entire account and spend it unwisely before he is able to understand the benefit of allowing the money to grow tax-free over his lifetime. For example, Paul established a trust for the benefit of John and named it as the beneficiary of his retirement account. Paul died when John was 20 years old. In the trust document, Paul stated that Mary, as trustee of John s trust, was to manage the assets in the trust until John reached 30 years old, or earlier if Mary believed John was able to handle the responsibility. Even though John is an adult, Paul has made sure that someone with more experience and maturity will manage the retirement account distributions until John is old enough to make wise decisions. If Paul had named John as the beneficiary directly, John would be able to do with the account as he pleased at age 20 without Mary s supervision and without regard for John s level of maturity. In addition, when you designate the trust as your retirement account beneficiary instead of your child, you protect this money from third parties, including your child s spouse in a divorce or your child s creditors. For example, If Paul designated a trust for John as the beneficiary of his retirement account, if John ever got divorced, his spouse would not have access to the money in the retirement account because it would be protected by the terms of the trust. This protection would not be available to John if he was the direct beneficiary of the retirement account. Furthermore, if John was ever in an accident and was sued as a result, the plaintiff would not be able to access the money in the retirement account if the trust was the beneficiary. Unfortunately, this would not be true if John was the direct beneficiary. 6

8 THE RULES FOR NAMING A TRUST AS A BENEFICIARY The reason that naming a trust as the beneficiary of your retirement plan can be so complicated is that the trust must qualify as a designated beneficiary. To qualify as a designated beneficiary the trust must satisfy four requirements and it must satisfy a fifth one if the trust beneficiaries are to have the option to stretch out the distributions over their life expectancy. First, the trust must be valid under state law. Second, the trust must be irrevocable. This can either be accomplished by will or by stating in the trust document itself that the trust becomes irrevocable upon your death. Third, all trust beneficiaries who will receive money from the retirement account must be identifiable from the trust document itself. This does not require that all beneficiaries be listed by name. However, if not listed by name, they must be easy to determine from the language used and, in particular, it must be clear who will be the oldest beneficiary since theirs will be the life expectancy used to determine minimum distribution amounts. Fourth, documentation of the trust must be provided to the retirement plan administrator by October 31 st of the year after the year of your death. If a trust meets these four requirements, it will qualify as a designated beneficiary; however, the trust beneficiaries will not have the option of stretching out the distributions over their life expectancy. To qualify for that option, the fifth rule that must be satisfied is that all trust beneficiaries must be individuals. As mentioned above, in the case of multiple trust beneficiaries, distributions from the retirement account will be taken out based upon the oldest beneficiary s life expectancy. This can be a problem if both your spouse and your child are beneficiaries of the same trust because your child would be forced to receive distributions over his parent s life expectancy instead of his own, longer life expectancy. Fortunately, through careful coordination between the trust document and the retirement account s beneficiary designation form, the trust can establish separate shares for your spouse and child and, if these shares are named as the retirement account beneficiaries, your spouse and child can take distributions over their own life expectancies. 7

9 It is probably clear to you by now why the misconception that a trust can never be designated as a beneficiary for a retirement account exists. It is a complicated process and one that should be done with careful attention and planning. However, hopefully it is also clear that in certain situations, this complicated process is worth going through since naming a trust as the beneficiary of your retirement account offers your loved ones important protections that are not available to them if they are directly named as beneficiaries. For more information on trusts and retirement accounts, please do not hesitate to contact our office. Caitlyn K. Walters works closely with clients on estate planning matters for young families. To inquire about a Complimentary Initial Consultation, visit our website at, cwalters@estateplanningmatters.com or call (301) Copyright 2012 All information contained in this Brochure is provided for informational purposes only, and should not be considered legal advice. This Brochure contains general information and may not reflect the most recent developments in either Federal law or the law of any state. Anyone who reads this Brochure, clients or otherwise, should seek the appropriate legal or professional advice from an attorney licensed in the reader s state regarding his or her specific circumstances and should not act or refrain from acting on the basis of any content in this Brochure. ( The Firm ) expressly disclaims all liability with respect to actions taken or not taken based on any or all the contents of this Brochure Executive Park Terrace, Germantown, MD fax: