One of the most confusing, and potentially costly, estate planning issues relates to beneficiary designations on retirement plan accounts.
A retirement plan beneficiary designation is a contractual agreement between the account owner and the company holding the retirement plan assets. The agreement stipulates that the company will pay the account balance at the account owner’s death to whatever persons or entities the account owner designates through a beneficiary designation. The account owner can name one or more primary beneficiaries who will receive the assets and one or more contingent beneficiaries in the event the primary beneficiaries no longer exist or are deceased.
To encourage voluntary saving, retirement plans provide the opportunity for a tremendous economic benefit by allowing the account owner, or his or her beneficiaries, to defer, or even avoid entirely, the income tax on earnings over time. Here’s a breakdown of two types of accounts:
- Traditional account. The employee gets an income tax deduction when contributing assets to the plan, whether it’s an IRA or an employer-sponsored plan like a 401(k) or profit sharing plan. Earnings on those assets while in the plan aren’t subject to income tax, but distributions from the plan are subject to income tax at ordinary rates in their entirety.
- Roth account. The employee doesn’t get an income tax deduction when the funds are contributed. While in the plan, earnings on those assets aren’t subject to income tax; but if certain requirements are met, then distributions also aren’t subject to income tax.
The great advantage of these vehicles is that the employee, and often his or her beneficiaries, is allowed to use the government’s erstwhile tax money as a sort of free loan to make money for his or her personal benefit. The more time funds are allowed to accumulate and grow in the account, the greater the value of the tax-free growth over time. A corollary to this rule is that, if possible, it behooves the account owner to take as little as possible from these accounts as late as possible, which generally means limiting withdrawals to the minimum required by law. This strategy is referred to as stretch-out.
What happens if there is no beneficiary designation or the named beneficiary or beneficiaries predeceased the account owner?
In either of these cases, which are functionally the same thing, you need to look at the agreement governing the account. For an employer-sponsored plan like a 401(k) or profit sharing plan, that would be the plan document. For an IRA it would be the account agreement where the account was opened.
Some agreements provide a default distribution that attempts to predict the distribution method that most people would want. The default distribution might provide that the account go to the surviving spouse, or in the absence of a spouse it might go to the account owner’s children, for example. However, many employer-sponsored plans and most IRA agreements provide that in the event there’s no beneficiary designation, then the account is payable to the account owner’s estate.
If the account is payable to the account owner’s estate either by default, as described above, or because the account owner actually named his or her estate as the beneficiary, the account is a probate asset that will be distributed according to the terms of the account owner’s will. If there’s no will, then it will be distributed by the applicable state’s laws of intestacy, which create default rules that attempt to predict to whom most people would like their assets to pass to in the event that they die without a will.
The problem is the five-year rule applies whereby the entire account must be distributed within five years of the account owner’s death, with one exception. Spreading the distributions over five years can mitigate the tax effect, but the compounding potential of stretch-out is lost. The one exception: if it’s a traditional account and the account owner already reached his or her required beginning date, then the estate has the option of taking distributions over the original account owner’s life expectancy. While better than the five-year rule in most cases, it’s still far worse than being able to take advantage of stretch-out.
What else can go wrong with beneficiary designations?
- Beneficiary designations are incomplete
Example: Ron has a wife and children. He names his spouse as the primary beneficiary but he never completes the contingent beneficiary designation section to name his children. If Ron’s wife predeceases him, on his subsequent death there would be no beneficiary designation and the account would be treated as a probate asset as described above.
- Beneficiary designations name an obsolete beneficiary
Example: During Marie’s first marriage she opened an IRA account naming her first husband as beneficiary. A few years later they divorced and Marie eventually remarried. Unfortunately, she never changed her beneficiary designation on her IRA to her new husband, and on her subsequent untimely death the account was payable to her former husband against her wishes, creating worry, confusion, and complexity.
- Beneficiary designations aren’t thought through
Example: Ned is an executive with a $2 million retirement plan balance. He also has two adolescent children. He names his wife as the primary beneficiary of the retirement plan and his two children as the direct contingent beneficiaries. Ned and his wife are killed in a common disaster and because they are named the direct contingent beneficiaries, each child will get outright ownership of his or her $1 million share at age 18.
If they have the discipline to take just the minimum required, the value of the stretch-out over their lifetimes will be tremendous. One of the children, however, upon turning 18 withdraws the entire account over a few years, using it for frivolous purposes and paying income taxes at very high top marginal rates. Later in life he realizes he squandered a tremendous economic benefit and deeply regrets not having the maturity to deal with the asset responsibly.
Breakdown by Beneficiary
Now that we’ve described some ways things can go wrong, let’s describe the consequences of naming particular classes of beneficiaries and what issues might be presented.
While some classes of beneficiaries are almost always the primary beneficiary (a spouse, for example), their status as a primary or contingent beneficiary is irrelevant to the result should they become entitled to some or all of the retirement account. While any beneficiary has the option of taking the entire account balance immediately, doing so means lumping the income in one year which can result in paying tax at higher marginal rates, and foregoing the benefits of stretch-out.
These options, organized by beneficiary option, provide the opportunity to avoid or minimize unfortunate results:
If the account owner is married, the spouse is named the primary beneficiary in all but the most unusual cases. In fact, if the plan is an employer-sponsored plan governed by the Employee Retirement Income Security Act of 1974 (ERISA), the account owner can’t name anyone other than his or her spouse unless that spouse assents in acknowledged, or notarized, writing.
The good news is spouses have an option that no other beneficiary has: He or she has the option of doing a spousal rollover into an IRA, which treats it like it was his or hers from the outset. So if a husband is 10 years older than his wife and dies at age 70 before required minimum distributions were to commence, his spouse could roll it into her own IRA and wouldn’t need to begin taking required minimum distributions until she turns 70 and a half, 10 years later.
However, if the surviving spouse needs to access the funds before he or she turns 59 and a half, a spousal rollover may not be the best option. If she does the spousal rollover, it’s treated as if it was hers at the outset and she’s subject to a 10 percent penalty for withdrawals prior to age 59 and a half. In that case, she would be better off treating it as an inherited IRA, which would require her to begin taking required minimum distributions the year after her spouse’s death, but would also allow her to take as much as she wanted to beyond that without penalty.
- Non-spouse individual
A non-spouse individual beneficiary has only one stretch-out option: to roll his or her share of the account into an inherited IRA. Unlike one’s own retirement account, the owners of an inherited IRA must begin taking required minimum distributions by the end of the year following the original account owner’s death. This is true regardless of the inheritor’s age. Even if he or she is two years old, required minimum distributions are required.
- Charitable beneficiary
If the account owner has a charitable intent, retirement plan assets can be a very attractive asset to give to charity. The charity can cash the account out immediately and not have to pay any income tax on the distribution because it’s a tax-exempt entity. This obviously is of no benefit in the case of Roth accounts, but can be of tremendous benefit in the case of traditional accounts where 100 percent of distributions to beneficiaries other than charities are subject to income tax at ordinary rates.
- Trust for the benefit of minor children
It’s tricky figuring out how to make sure minor children are the beneficiaries of retirement plan benefits in a way that doesn’t give them unrestricted control while they’re still young. The best option is for the account owner to name his or her revocable trust as the beneficiary for the benefit of his or her children.
In order for that to work, the trust needs to be what’s known as a qualified trust or the account will be treated as having no beneficiary, according to the five-year rule as described above. If you haven’t updated your trust since about 2001, which is the year the qualified trust rules went into effect, then it will be need to be updated. It’s also important to have a qualified trust and estates attorney confirm the status, even if the trust appears to have adequate language.
Even if the trust does qualify, the trust will take the age of the oldest beneficiary as the measuring life for determining required minimum distributions, unless specific provisions are in place. This is a disadvantage for younger beneficiaries who, if they had their share in their own inherited IRA, would be able to take it out over their own longer life expectancies. Trusts can provide that each beneficiary use his or her own life expectancy for his or her share, but the trust needs specific language to accomplish that.
- Per stirpes or by right of representation designations
The default rule for beneficiary designations is if a group of people is named at a particular level (as primary or contingent beneficiaries, for example), and one or more members of that group predecease the account owner, then the surviving members equally share the account. While at first blush that sounds like the right result, it usually isn’t.
For example, let’s say a father names his three children as primary beneficiaries of his retirement plan and each of his children have children of their own. If one of his children predeceased him, in most cases he would want that child’s children to share the share the child would have received. This is known as distribution “per stirpes” or “by right of representation.” However, under the default rule, the children of the predeceased child would be functionally disinherited in this scenario.
Some retirement plan beneficiary designation forms provide a check box where per stirpes or by right of representation can be elected, though some require a person be designated to certify to the company holding the account who the legal takers are in the event it’s triggered. In the absence of that, in the example above, the father could simply write the phrase “per stirpes” or “by right of representation” after each child’s name. If the company accepts the designation as written without objection, then arguably it has the contractual obligation to honor and enforce it.
Getting beneficiary designations wrong can have profoundly negative consequences for the people and entities the account owner intended to benefit. Understanding what those consequences are, and the options available to get them right, is essential to good estate planning.
We’re Here to Help
Designating beneficiaries for your retirement plan can be confusing and potentially costly. If you’d like to know more about your own estate planning and the ramifications of various choices, please contact your Moss Adams professional.