The importance of beneficiary designations
Coordinate your beneficiary designations with your estate and wealth management plans
Many people jeopardize the effectiveness of their estate plans by forgetting to create or regularly update their beneficiary designations on IRAs, other retirement plans, and life insurance policies. Consider these factors as you complete or revise your beneficiary designations.1
The designations in your plan control where your money goes
Your beneficiary designations control who gets your IRA and other retirement plan assets. You cannot change your beneficiary by naming someone in your Will or in a trust. The custodian of your retirement assets will only look at the beneficiary designation in its files.
Name a beneficiary or beneficiaries
If you don’t name a beneficiary, or if you name your estate or certain trusts as the beneficiary of a retirement plan, your heirs will be forced to withdraw the assets from the retirement account in full—and pay ordinary income tax on the withdrawals—within five years from your death. This five-year rule can also apply to other, less-common situations. This isn’t the optimal situation.
A named beneficiary can “stretch” distributions from the account over his or her life expectancy, and can also name subsequent beneficiaries.2 The stretch provision allows the beneficiary to defer paying taxes on the account balance until funds are withdrawn, which preserves more of the principal for your heirs. The named beneficiary must take minimum required annual distributions—calculated using his or her life expectancy—to avoid a penalty.
In most instances, a spouse is the appropriate beneficiary of your retirement assets, and he or she can roll your retirement assets into his or her own account (essentially taking ownership of the inherited account). Your spouse must give consent if you name someone else as your beneficiary. If you are charitably inclined, you can name one or more charities as the beneficiaries of your retirement, which would avoid both income and estate taxes. In any event, you should consult legal and tax counsel to understand the tax effects of naming individuals and entities as beneficiaries of your retirement accounts.
Naming a trust to protect your beneficiaries
Inherited IRA and retirement plan assets generally are not protected from the bankruptcy creditors of the beneficiaries.3 In light of that, you may wish to protect your assets by leaving them in trust rather than outright to your beneficiaries. While you probably don’t expect your heirs to go bankrupt, a trust can provide asset protection for other situations, such as a divorce. However, leaving retirement assets in a trust can have its own particular complications, which should be clarified with your tax advisor.
Trust as beneficiary—the requirements for the “stretch”
In order for a trust to be an IRA beneficiary that qualifies for the “stretch,” it has to meet a number of criteria. (Generally, it needs to be a “look-through” trust, which enables you to use the age of the trust beneficiary to calculate the amount of the stretch distributions.) The beneficiary or beneficiaries have to be individuals who are identifiable within a short time after your date of death. So trusts that include powers of appointment, or that name charities as ultimate takers if all named individual beneficiaries are not living, may not qualify as look-through trusts, and can cause retirement assets left to them to be distributed and taxed within five years.2
Trust as beneficiary—key considerations
If a trust has only one beneficiary, using that beneficiary’s age to calculate the withdrawal rate is easy. If there are multiple beneficiaries, however, the age of the oldest must be used. Individuals typically do not leave retirement assets in trust for both a spouse and children because:
- The spouse will not be able to roll over the assets into his or her own name, which would also prevent any additional planning, such as a Roth conversion.
- The trust would have to use the spouse’s age to calculate withdrawals, which, in most instances, would reduce the ability to stretch withdrawals over the children’s life expectancies. As a result, trusts for spouses should generally be a consideration primarily if you have a blended family and want to ensure that your children from a different marriage eventually inherit your retirement assets.2
If you leave your retirement assets to a trust for the benefit of your children, you should consider two potential pitfalls, both of which depend on the length of the trust:
- If you expect to have a trust in place for a long time (such as your children’s lifetimes), consider who will act as trustee. Most of the people you know and trust will be dead by the time the trust terminates, and an institutional trustee will often have annual costs for acting as trustee (even if it is not acting as the investment manager). And the smaller the retirement account, the higher the costs relative to the account’s value.
- Once you name a trust as the beneficiary of your retirement assets, it can be difficult to terminate the trust and distribute the IRA to the trust’s beneficiaries. Should circumstances change, the trustee may decide that a trust is no longer necessary or desirable. But without express authorization, transferring the retirement account to the trust’s beneficiaries can be difficult.
If you do decide to name a trust as an IRA beneficiary, make sure you consult with a qualified estate-planning attorney. Often, existing trusts, or trusts that you create in your Will, may not be ideal for holding IRA assets. And you should name the specific trust in which you intend to hold the IRA (e.g., “the Trust created under Article IV paragraph 2 of my Revocable Living Trust”) rather than a more generic formulation (e.g., “my Revocable Living Trust”)—the difference between them could be the difference between your beneficiaries being able to stretch the required withdrawals and being unable to do so.2 You cannot rely on the IRA custodian to read and interpret your estate-planning documents the way you would, so be as clear as possible when designating your beneficiaries.
Talk to your J.P. Morgan representative to review your existing beneficiary designations, and make sure they are coordinated with the rest of your planning.
1This WealthFocus deals primarily with beneficiary designations for retirement accounts. While many of the same principles apply to life insurance beneficiary designations, some of the concerns addressed here are not present with life insurance, since the insurance policy is extinguished once it is paid.
2Proposed legislation may limit a beneficiary’s ability to stretch distributions. Consult tax counsel to understand how the stretch rules would apply to your beneficiaries.
3Clark v. Rameker, 134 S. Ct. 2242 (2014)
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