Estate Planning and Retirement Benefits

One of the final steps in completing an estate plan is to review and revise beneficiary designation forms for retirement accounts and other assets.  This article focuses on appropriately naming a beneficiary for a qualified retirement plan.

Often times, the answer to the question: “who should be the beneficiary of my retirement account?” is not simple.  For smaller estates with no complicating factors such as minor children, a disabled child or a second marriage, the answer may be as simple as naming the spouse as the primary beneficiary and children as contingent beneficiaries.  However, if, for example, you have minor children, it is not advisable to simply name the children because a custodian would have to be appointed by a court to manage the funds while the child is a minor.  The custodian would also have to render annual accountings to the court, and the child would be entitled to the account at age 18, which may result in unwise spending (think: fancy car or big parties).

To prevent distribution to a minor child, a trust could be named as the beneficiary of your retirement account.  But, the trust should be a qualified “see-through” trust as described further below.  If a trust is not desirable, a trustworthy individual may be named as a custodian under the Uniform Transfer to Minors Act.  The individual should be listed on the beneficiary designation form “as custodian for [name of minor child] under the Minnesota Uniform Transfers to Minors Act.”  By naming an individual as a custodian for the minor child, the need for court appointment of a custodian is eliminated and distribution of the account is not required until the child reaches age 21.

For larger estates over the current Minnesota Estate Tax exemption amount of $1.2 million, there may be estate tax planning reasons to not simply name your spouse as the primary beneficiary directly.  For example, if a credit shelter or marital trust will be utilized to reduce estate taxes and no other assets exist to fund such a trust, it may be necessary to name the trust as the beneficiary of a qualified retirement plan.  However, as noted below, naming your spouse as the beneficiary is the best and simplest way to preserve the income tax benefits of a retirement account, if at all possible.

Planning Goal

The most valuable feature of a qualified retirement plan is that income tax is deferred on compensation contributed to the plan and the investment profits thereon.  The contributions and gain grow in the plan tax deferred, which means that you are not just investing your money, but also “Uncle Sam’s share” of your compensation that would otherwise have been subject to income tax in the year earned.  The longer assets stay in the retirement account, the longer you get to invest “Uncle Sam’s” share, and the power of compound interest gets to work (hopefully).  Therefore, it is important to name appropriate beneficiaries to permit the “stretch out” of payments from retirement benefits over the life of a beneficiary thereby maximizing continued growth in the account.

Basic Minimum Distribution Rules

Congress created tax deferred retirement accounts to encourage saving for retirement, but created rules to prevent individuals from using retirement accounts to accumulate and transfer wealth (instead of spending during retirement).  The rules are referred to as the “minimum required distribution rules” and they compel annual minimum required distributions (“MRDs”) from plans beginning at age 70 ½ or death, whichever is earlier.  The “minimum required distribution” rules are contained in Internal Revenue Code (IRC) Section 401(a)(9) (“MRD Rules”) and apply to most retirement plans, including 401(k) plans, defined benefit or pension plans, ESOPs, Keogh plans, and profit sharing plans (though the Rules vary based on the type of plan).  A “qualified retirement plan” is a retirement plan that meets all the requirements in IRC 401(a) and all those listed above are considered a qualified retirement plan.  An IRA is not subject to the MRD Rules, but is subject to similar minimum distribution rules contained in IRC Section 408(a).

The MRD Rules describe when distributions must start and once they begin, how much must be distributed each year.  The general rule is that retirement benefits must be completely distributed over the life or life expectancy of the participant or (within limits), the life expectancy of the participant’s beneficiary.

Some other basic requirements of the MRD Rules, include:

• Annual Distributions must be taken by December 31 each year.
• The MRD is determined by dividing the prior year-end account balance by a factor from an IRS table on life expectancy.
• Taking more than required in one year does not give you a credit you can use to reduce distributions in a later year.
• The plan may be stricter than the regulations.
• Distributions before the first MRD don’t count.

Natalie Choate, Life and Death Planning for Retirement Benefits.  29 (6th Edition 2006).

After a participant’s death, the MRD Rules apply to the beneficiary of the retirement account.  Generally, the participant’s retirement benefit can be distributed over the life expectancy of the nominated beneficiary so long as that beneficiary is considered a “designated beneficiary” under the MRD Rules.  However, not every named beneficiary qualifies as a “designated beneficiary.”  For example, if your “estate” is named as the account beneficiary it will not be considered a “designated beneficiary.”  Therefore, it is not generally advisable to name your “estate” as the beneficiary of a qualified retirement plan.  Only an individual, group of individuals or a qualifying “see-through” trust can be a designated beneficiary (“DB”).

If a named beneficiary is not a DB, this can result in the benefit having to be paid out in a short period of time (as short as 5 years) which means: 1) income tax will need to be paid on the distributions and 2) the nominated beneficiary will not be able to “stretch out” the benefit which will eliminate the continued investment of tax-deferred compensation.

Designated Beneficiary

After a participant’s death, calculation of the MRD depends on the identity of the DB.  As discussed above, in a situation where a participant has a spouse and grown children, determining who to name as the beneficiary is often more simple.  The participant is usually comfortable naming his or her spouse as the primary beneficiary and the adult children as the contingent beneficiaries.  However, complicating factors such as a minor or disabled child create a situation in which the participant may want to name a trust as the beneficiary so the benefit can be managed for the child’s benefit.

If the sole DB is the spouse, the spouse is given the added special privilege of being able to roll over, tax-free, the benefit to his or her own retirement plan AND the MRD will then be calculated using the much more generous Uniform Lifetime Table, IRS Reg. §1.401(a)(9)-9,A-3.  This means that the spouse can then “stretch-out” the benefit over his or her lifetime instead of having to take distributions based on the lifetime of the decedent or some other shortened timeframe.  Moreover, the spouse can then name her own beneficiaries who would take based on their lifetimes when the spouse dies.  Whereas, if the spouse does not roll over the benefit, the spouse can still name her own successor beneficiaries, but the successor beneficiaries would take based on the life of the participant resulting in much larger MRDs and quicker depletion of the benefit.

Additionally, if the spouse rolls over the benefit it is not considered an “inherited plan.”  In June, the Supreme Court unanimously held that funds held in inherited IRAs are NOT protected as “retirement funds” within the meaning of the Bankruptcy Code.  Therefore, creditors would have access to an inherited right in bankruptcy proceedings.  As a result, in some circumstances, it may be important to discuss the option of having an IRA payable to a “see-through” trust instead of naming the individual outright.

If an individual other than the surviving spouse is the DB (such as a child), then the benefit is paid out based on the life expectancy of that individual (as determine by the Single Life Table in the MRD Rules).  If there are multiple individuals named as beneficiaries, the MRD will be calculated based on the life expectancy of the oldest beneficiary unless separate accounts are established by December 31 of the year of death or a beneficiary is removed by disclaimer.

Naming a Trust as Beneficiary

For those situations where a participant does not wish to name a spouse or child outright or where for estate tax reasons it makes sense to name a trust as the beneficiary of a retirement account, it is crucial to ensure the trust is a “qualified trust” under the MRD Rules.  A qualified trust is often referred to as a “see-through” trust, which means the life expectancy of the individual trust beneficiaries (usually the oldest) is considered the life expectancy for purposes of the MRD Rules and a “stretch out” of the benefits can occur.  To qualify as a “see-through” trust, there are a number of rules that must be met.

If you are naming a trust as the beneficiary of your qualified retirement account, be sure to discuss the ability to preserve the “stretch out” of payments over the lifetime of the trust beneficiaries with your advisors.  The correct nomination of beneficiaries for retirement plans (and any other asset with a beneficiary designation form) is important and should be reviewed with your attorney.

Mia E. Thibodeau is an attorney with Fryberger, Buchanan, Smith & Frederick, P.A., and practices in the areas of family law, estate planning, real estate and municipal law.