Now, more than ever before, Americans are using a variety of tax-deferred accounts such as 401(k)s and IRAs to save for retirement. For many of my clients, their retirement account is their largest asset. And while the laws are currently designed so that people must start withdrawing the money around the time they retire, it is not uncommon for many of these accounts to still have significant value at the owner’s death. As a result, a huge amount of accumulated wealth is just waiting to be passed on to loved ones over the next few decades as retirement account owners age and die. Many people are unaware that there are numerous options for transferring these types of accounts to their loved ones. For purposes of this article, we will use “IRA” to refer to a retirement account because many people end up rolling over their 401(k) and other similar retirement accounts into an IRA to obtain greater investment options.
Distribution Outright through Beneficiary Designations
By far the most common way to leave your IRA at your death is to simply name those whom you want to receive your account as beneficiaries on the plan’s beneficiary designation forms. You can leave 100% of it to one person (such as your spouse), or you can leave a percentage or fraction of your account to multiple beneficiaries, including children, grandchildren, and even charities. When you die, the beneficiaries will be responsible for filing death benefit claims with the account custodian to receive their portion of the IRA account.
The paperwork for filing such a claim typically offers a variety of options for requesting the distribution. Options can include (a) a spousal rollover (if the beneficiary is the spouse of the plan participant), (b) establishment of an “inherited IRA” account either with the original custodian or by transferring the account to another account custodian as an inherited IRA, or (c) a lump-sum distribution. In some cases, there may be an option to make periodic payments from the IRA to the beneficiaries, depending on the type of investment in the IRA (such as an annuity).
Each of the above options has different tax implications that the beneficiary should carefully consider before making the claim. Be sure to educate your beneficiaries about these options and encourage them to seek professional advice before making their claims.
A number of IRA custodians are now offering another option called a trusteed IRA. A trusteed IRA is an IRA account that becomes a trust account at the death of the plan participant through the addition of trust terms and language to the custodian’s IRA agreement. The specific trust options can vary widely depending on the financial institution that has established the trusteed IRA. Typically, however, trusteed IRAs are designed to maximize the amount of time over which an IRA must be paid out to the beneficiary to ensure some level of protection against a beneficiary who carelessly spends money or who is at risk of divorce, lawsuits, creditors, and predators. A trusteed IRA can also allow you to name successor beneficiaries if your first beneficiary dies before the account is fully distributed.
Please note that not all financial institutions offer trusteed IRAs. Also, trusteed IRAs typically name the financial institution or custodian as the trustee of the account instead of allowing you to name as trustee a family member or friend whom you trust to make distribution decisions. Finally, most trusteed IRAs prevent the transfer of an inherited IRA to another financial institution, thereby locking your beneficiaries into working with your original IRA custodian.
One significant disadvantage to using a trusteed IRA is that it is generally less capable of providing the same level of asset protection that an actual trust, drafted under specific state laws, can provide. Because trusteed IRAs are standardized documents drafted to comply with the laws of most if not all states, there is very little ability to customize the terms of the trust to obtain the specific goals that you may have for your beneficiaries. Another disadvantage is that the trustee may charge a fee before the participant’s death.
Custom Retirement Assets Protective Trust
Another option for IRA account owners is a customized retirement benefits trust, sometimes called a standalone retirement trust or IRA protection trust.
A revocable living trust (RLT) is used by many as the foundation of an estate plan. Although naming an RLT as the beneficiary of your retirement account is possible, there are a number of potential traps that you need to avoid if you name your RLT as the beneficiary of your IRA.
First, RLTs typically allow the deceased individual’s expenses or debts to be paid before anything else, making a retirement account payable to an RLT (as beneficiary) available to be used to pay the decedent’s creditors. Being forced to draw funds from an IRA can needlessly accelerate the taxation of those funds and should be avoided if possible.
Another pitfall of naming your RLT as the beneficiary of your retirement account relates to the rules around the issue of what qualifies as a “designated beneficiary” for tax purposes. Though qualifying an RLT as a designated beneficiary is possible, it can make achieving your other goals very tricky. For example, people often name a charity as a remote contingent beneficiary of their RLT (the beneficiary who inherits the trust’s money and property if all of the trustmaker’s other beneficiaries die first). But that can actually disqualify the RLT as a designated beneficiary, causing all beneficiaries to have to prematurely withdraw the IRA funds and exposing them to increased or accelerated income tax liability.
For these reasons, many IRA account owners should consider using a separate retirement benefits trust, which is specifically for retirement accounts. With such a trust, tax planning for the retirement assets can be achieved while also providing asset protection for the IRA assets, keeping the assets from the reach of a divorcing spouse, creditor, or predator. Meeting these twin goals of tax planning and asset protection is desirable for all beneficiaries and also can help if meeting goals related to some specific situations that may be present. Such trusts work well in second marriage situations where one spouse wants to support a current spouse during that spouse’s remaining lifetime while making sure that what remains is paid out to the children from the first marriage. In other cases, an IRA account owner may have a disabled, spendthrift, or minor beneficiary and wants to provide much greater control and protection of those retirement benefits than an outright distribution can provide. A retirement benefits trust can help you ensure that retirement benefits that you leave to a loved one are used for only those things that you would approve of and are protected from people who should not have access to them.
Another option for providing retirement account funds to a loved one, particularly when you want to leave money to a minor child, is a custodial IRA or a custodial Roth IRA. With these types of accounts, a parent makes a contribution to an IRA in the name of the child but lists the parent (or another responsible adult) as the account’s custodian. This option can provide not only tax-deferred growth that retirement accounts are designed to provide, but also some control by the named custodian regarding future contributions to or withdrawals from the account.
Note that the minor will typically be allowed to access the account upon reaching age eighteen (or in some states, twenty-one). One of the benefits of these types of accounts is that there are typically no penalties for early withdrawals made for qualified education purposes.
As you can see, you have a variety of options for leaving retirement benefits to your loved ones. Your goals for your beneficiaries will help you determine which options are right for you. If you need help to more fully understand the implications of these options, please schedule time to meet with us. We can help you sort through the pros and cons of each option.