Did you complete Your IRA Beneficiary Form Properly? IRA Beneficiary Planning 101

This article was written by KKOS Attorney Kevin Kennedy.

Two of the main benefits of setting up an IRA or other retirement account are its tax-preferred treatment and its protection from creditors.  There are exceptions to this and depending on the type of retirement account and where you live, there will be varying levels of creditor protection and tax benefits, but these are two of the main reasons why someone would spend years saving and building their retirement account.  The question then becomes what happens to these benefits when you die?  In other words, how will your retirement account be taxed in the hands of your loved ones and will these funds be protected from their creditors?

These are very important questions and the answers will depend in large part on how you fill out your retirement account beneficiary designation form.  This form will typically allow you to name a primary beneficiary which is your first choice to receive the funds upon your death and a secondary beneficiary which would be the backup in the event your primary beneficiary dies before you.

There are many options for whom to name as primary beneficiary and secondary beneficiary, but the common method is to name your spouse if you are married as the primary beneficiary, and then either name a trust if you have one, or your children if you have children as the secondary beneficiary.  While this may be a good general rule to follow, there are many factors which should be considered before deciding who to name as primary and secondary beneficiary. Once all of the appropriate factors have been considered, then you can decide how to fill out your beneficiary designation form.  Much of it will come down to deciding whether to name individuals or trusts, or a combination of both.  With that, here are some items to consider when naming an individual or trust as a beneficiary on your beneficiary designation form:

If you name an individual on your beneficiary designation form:

1. Taxes: In terms of how your retirement account will be taxed in the hands of your loved ones after you die, depends  on who receives your account. That’s one of the problems with naming an individual is that they get to make the decision.  If they’re in a tough situation financially, they may cash out your retirement account immediately without regard for the hefty taxes that can result.  On the other hand, even if your loved one does not need the funds immediately and wants to save on taxes, unfortunately, the time will come when required minimum distributions (RMD’s) must be taken out.   Given that reality, typically the goal is to minimize the taxes due by having the RMD’s paid out over the longest period of time allowable under the Tax Code.  This option is sometimes referred to as the Stretch Option.  This option is generally available to both a spouse or non-spouse.  Mat Sorensen has written an excellent article on the options available to a spouse or non-spouse beneficiary, which you can read here.  Basically, a spouse who wants to stretch out the taxes due can rollover these amounts to their own retirement account or setup an inherited IRA, but a non-spouse who wants to stretch out the taxes due can only setup an inherited IRA. One of the ways to “force” your loved ones to take advantage of the Stretch Option is to name a trust as the beneficiary on your beneficiary designation form.  Then upon your death, the retirement account funds would go to the trust so that eventually the funds would be passed to your loved ones, but only upon the terms and conditions of the trust.   However, one of the risks of naming a trust on your beneficiary designation form is if it doesn’t meet all of the necessary requirements, you will forfeit the Stretch Option and the retirement funds will be distributed within 5 years. We’ll discuss the trust requirements later in this article.

1. Creditor Protection. If you name your spouse on the beneficiary designation form, and they elect to rollover your retirement account to their own IRA, that amount will continue to receive creditor protection.  But if your spouse or other loved one decides to cash out your IRA, that amount will have lost all of its creditor protection.  Significantly, even if your loved one elects not to cash out your retirement account but instead decides to have your retirement funds rolled over into an inherited IRA, such an account is more vulnerable to creditors than a non-inherited IRA, i.e., the retirement account during the retirement account owner’s lifetime.

1. Other Considerations. If you are currently married and this is not your first marriage and you have children from a prior marriage or relationship, be careful to name your spouse because this means that if you die, and your spouse rolls over your retirement account to their own IRA, for example, they are under no obligation to name your children from a prior marriage as beneficiaries on your spouse’s beneficiary designation form.  In order to prevent that, you may need to figure out another option, including but not limited to naming a trust as the beneficiary on your beneficiary designation form.  However, one of the risks of naming a trust on your beneficiary designation form is if it doesn’t meet all of the necessary requirements, you will forfeit the Stretch Option and the retirement funds will be distributed within 5 years.

If you name a trust on your beneficiary designation form:

1. The risk of naming a trust on your beneficiary form is if it doesn’t meet certain requirements you and your loved ones will forfeit the Stretch Option.  The consolation prize is that your loved ones will have 5 years to have your retirement account fully distributed, but depending on the size of your retirement account, and the income tax bracket of your loved ones, this can nevertheless result in a significant tax bill.  The requirements that your trust must comply with in order to not forfeit the Stretch Option can be found here.  Basically, the trust must be considered what is sometimes referred to as a “see through” trust.  The reason for this nickname is because in order to take advantage of the Stretch Option, there must be an individual or individuals whose life expectancy can be used to determine the amount of the RMD’s to be paid over time.   In other words, the IRS must be able to “see through” the trust and identify the beneficiary or beneficiaries of the trust.  These requirements beg the question, what kind of trust needs to be setup in order to meet these requirements?  The two most common types of trusts that are discussed in this situation is the IRA Trust and the Family Trust or Revocable Living Trust.  An excellent article written by Mat Sorensen on myths and facts about the IRA Trust can be found here.   If properly drafted, both the IRA Trust and a Family Trust/Revocable Living Trust can satisfy these requirements.  However, there are many reasons why it would be preferable to name an IRA Trust and not a Family Trust/Revocable Living Trust, and vice versa.  In short, if your IRA has over $500K of value and if you want any restrictions on the use of the IRA funds upon your passing, a separate IRA Trust would be a benefit. Such a topic will be the subject for another blog, but regardless, you will absolutely want to have your trust reviewed by a competent professional before naming it on your beneficiary designation form to make sure you don’t unintentionally forfeit the Stretch Option.

1. Creditor Protection. One of the main benefits of naming an IRA Trust as beneficiary on your retirement account beneficiary form is that when you die your retirement account funds will be protected from the creditors of your loved ones.  Depending on the circumstances and how the Family Trust/Revocable Living Trust is drafted, the same may also be true.

1. Other Considerations. One of the benefits of a properly drafted trust that meets the requirements of the Stretch Option is that instead of having the age of the oldest beneficiary used to calculate the RMD’s under the Stretch Option, each beneficiary can use their own age and thus allow the younger beneficiary’s to further maximize the Stretch Option.  This is accomplished by having the trust properly drafted to create sub-trusts for each beneficiary. Therefore, it may be advisable to prepare a customized beneficiary designation form and provide it to your retirement account administrator to sufficiently address these sub-trusts and their respective beneficiaries.

Naming beneficiaries on your beneficiary designation form can be one of the most important decisions you make in your estate plan and part of that is to understand the tax treatment and creditor protection of your retirement account after you die.  Please consult with a competent attorney or tax professional to make sure it gets filled out to properly reflect your objectives and to determine whether it’s preferable to setup an IRA Trust, a Revocable Living Trust/Family Trust, or both and how to properly incorporate them into your IRA beneficiary planning.

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