“What happens to your retirement accounts when you die?”
My first answer would be another question: What do you want to happen? That may sound like I am avoiding the question, but I am not. Retirement accounts are different from many other assets because they generally do not pass according to your Will. Instead, what happens after your death depends primarily on the beneficiary designation you made with the financial institution or retirement plan administrator.
That means you have several different levels of planning available, ranging from essentially doing nothing and accepting whatever the account agreement says, all the way up to creating a specialized trust designed specifically to receive retirement benefits.
The important question is not simply, “Who should get my retirement account?” You also need to think about how they should get it, when they should have control of it, what happens if something goes wrong in their lives, and how much importance you place on the income-tax treatment of those retirement dollars.
These questions become especially important when the account is large or when the beneficiary is young, financially irresponsible, facing creditor problems, or potentially headed toward a divorce.
So, beginning with the least control over what happens and moving toward the greatest control, here are four different ways your retirement accounts can pass after your death.
You Name No Beneficiary at All
This is the lowest level of planning because you are essentially allowing the financial institution or retirement plan to decide what happens based upon the contract you agreed to when the account was established.
People sometimes assume that if they never filled out a beneficiary form, their Will automatically controls the retirement account. That is not necessarily true. The first place we have to look is the retirement account agreement itself. Many agreements provide that if there is no beneficiary on file when the account owner dies, the account goes to the deceased owner’s estate. I have also seen agreements containing a default order of beneficiaries that may send the money directly to a spouse, children, or other next of kin instead.
In other words, if you fail to make a beneficiary designation, you have still made a choice. You have chosen whatever default choice the financial institution wrote into its paperwork.
If the estate becomes the beneficiary, that can be particularly undesirable. Instead of having an individual designated beneficiary, the account may be subject to less favorable post-death distribution rules. Under current federal rules, an estate is not treated as an individual designated beneficiary, and the distribution period can depend upon whether the account owner died before or after the required beginning date for required minimum distributions.
That is why the first question should never simply be, “Do I have a Will?” It should also be, “Who is actually named on my retirement accounts?”
You Name the Beneficiaries Directly
This is by far the most common approach. You fill out the beneficiary designation, perhaps naming your spouse first and your children as contingent beneficiaries, and the retirement account passes directly to those people after your death.
There are some significant advantages to this. The account generally passes outside probate, and you know who is supposed to receive it. For many non-spouse beneficiaries, current federal law generally requires the inherited account to be emptied by the end of the tenth year following the owner’s death, although the exact required-distribution rules depend upon the beneficiary, whether the owner had reached the required beginning date, and several other factors. Certain beneficiaries—including surviving spouses, minor children of the owner, disabled or chronically ill individuals, and people not more than ten years younger than the owner—can qualify for different treatment.
For a typical adult child who inherits an IRA, one of the advantages is that the beneficiary may be able to maintain the account as an inherited IRA rather than taking the entire taxable amount immediately. That can allow the income-tax consequences to be spread over the applicable distribution period rather than voluntarily cashing out the entire account in the first year. Exactly when distributions must be taken during that ten-year period depends upon the circumstances, so “ten years” should not be confused with an automatic right to take one-tenth every year.
But there is an enormous estate-planning weakness with naming a beneficiary directly: once that beneficiary receives control, your protections are generally gone.
Suppose your Will says your son should not receive complete control of his inheritance until age thirty-five. But your IRA beneficiary designation names your son directly. The retirement account does not stop at your Will on the way to your son. It bypasses the Will.
The same problem exists with a Revocable Living Trust. You might have an extremely detailed Trust providing that your twenty-year-old granddaughter’s inheritance should be managed for her until she reaches thirty, with money available for education, medical care, housing, and other legitimate needs in the meantime. But if you name that granddaughter individually on the retirement account beneficiary form, the retirement account passes according to that beneficiary designation. The age restrictions you carefully wrote into the Trust do not magically reach outside the Trust and grab an asset that was never directed there.
The beneficiary designation wins because that is the instruction controlling that particular asset.
This also means you lose much of the protection you could otherwise build around an inheritance. There may be little you can do through your estate plan to control how quickly that person spends the money once it is in his or her hands, and you are not creating the same type of trust protection against creditors, lawsuits, bad financial decisions, or other problems.
So direct beneficiary designations can be excellent for simplicity and potentially favorable retirement-account tax treatment, but simplicity comes at a price: you are giving up control.
You Name a Revocable Living Trust
The next level is for someone who looks at those tax advantages and says, “That is important to me, but protecting the beneficiary is more important.”
Instead of naming an individual directly, you can potentially name a properly drafted Revocable Living Trust as beneficiary of the retirement account. Now, when you die, the retirement benefit is received and administered under the Trust provisions rather than simply being handed outright to the beneficiary.
This can completely change the level of control you have.
If your daughter is twenty-three and you do not want her controlling the entire inheritance, the Trust can say that. If your son is terrible with money, the Trust can provide a trustee who manages the inheritance instead. If one of your beneficiaries has creditor or lawsuit problems, properly designed continuing-trust provisions can provide protections that simply handing the beneficiary the retirement money outright would not provide.
And you can design those protections around the individual beneficiary rather than pretending every person in your family needs the same plan. One child may receive an inheritance outright. Another may need protection until age thirty-five. A third may need lifetime asset protection.
Estate planning should be built around the people receiving the inheritance, not simply around the assets being transferred.
There is an important tax qualification here, however. Saying “name my Living Trust” on the beneficiary form is not enough by itself to guarantee the same retirement-account treatment that an individual beneficiary would receive. Federal tax law contains specific rules under which the beneficiaries of a trust can be treated as designated beneficiaries for required-minimum-distribution purposes.
Among other requirements, the trust generally must be valid under state law, become irrevocable at death, have identifiable beneficiaries, and satisfy certain documentation requirements.
That is why a general-purpose Revocable Living Trust that was never drafted with retirement benefits in mind can create tax results very different from simply naming an individual. The planning question becomes a balancing act: How much tax efficiency do you want, and how much control and protection does the beneficiary need?
For many families, protection wins.
You Use a Specialized IRA Trust
For a large retirement account, however, you may not want to choose between the two.
You may want the strongest beneficiary protections you can reasonably obtain and the best available treatment of the inherited retirement account under the tax rules. That is where a specialized retirement-benefits trust—often called an IRA Trust—can become extremely valuable.
An IRA Trust is drafted specifically around retirement assets rather than merely treating the retirement account like every other asset in the estate. The objective is to satisfy the federal rules that can allow the underlying individual trust beneficiaries to be recognized for purposes of the post-death retirement-account distribution rules while still keeping the inheritance inside a protective trust structure.
The IRS specifically recognizes circumstances in which beneficiaries of a properly qualifying trust can be treated as designated beneficiaries even though the trust itself is named on the account.
Now we can begin combining tax planning with estate-planning control.
Instead of simply giving the inherited retirement account to the beneficiary and hoping everything goes well, the inherited account can be administered for the trust beneficiary under a carefully designed structure. The trustee can oversee the retirement asset and the required distributions, and the Trust can determine what happens when money comes out of the retirement account.
That distinction is extremely important. Taking money out of the IRA and giving it directly to your child are not necessarily the same thing. Depending upon how the Trust is designed, distributions that must come out of the inherited retirement account can potentially remain subject to the Trust’s terms rather than automatically becoming unrestricted money in the beneficiary’s hands.
Now you can build in the restrictions that actually matter to you. You can provide that a beneficiary does not receive outright control at eighteen, twenty-one, or twenty-five. You can create protections for someone who is financially irresponsible. You can provide management for someone who simply has no interest in investing money. You can address creditor and lawsuit concerns. And you can do all of that while designing the Trust specifically around the complicated federal rules governing inherited retirement accounts.
There is not one generic “IRA Trust” that produces the perfect tax result for everyone. Trust taxation, required minimum distributions, whether distributions are accumulated or passed through to beneficiaries, the identity of those beneficiaries, and whether someone qualifies as an eligible designated beneficiary all matter. But for a sufficiently large retirement account, having a trust specifically designed around those issues can be very different from simply typing the name of a standard Living Trust onto a beneficiary designation form.
The Bonus Protection: Divorce
There is one more reason I particularly like this kind of planning, and it has nothing to do with whether your child is irresponsible.
Your child could be extremely responsible and still get divorced.
Imagine leaving a $1 million retirement account directly to your daughter. She may have done absolutely nothing wrong, but ten years after your death she could find herself in the middle of a nasty divorce. Once inherited assets are distributed outright, mixed with other assets, spent on jointly owned property, or otherwise handled incorrectly, protecting that inheritance can become much more difficult.
A properly designed trust can provide another layer between the inheritance and the beneficiary’s personal financial problems. Instead of your goal being simply, “I want my daughter to inherit this money,” the goal becomes, “I want this money available for my daughter, but I also want to protect it from the things that could happen around her.”
That could mean creditors. It could mean lawsuits. And it could mean the son-in-law or daughter-in-law you liked very much when you signed your estate plan but who may not still be part of the family fifteen years later.
So, What Happens to Your Retirement Accounts When You Die?
We come right back to the question we started with.
What do you want to happen?
You can name nobody and accept whatever default provisions were buried in the retirement account paperwork years ago. You can name individuals directly and obtain simplicity and potentially excellent tax treatment, while giving up much of your ability to control and protect the inheritance. You can direct the account into a Revocable Living Trust and place greater emphasis on protection and control. Or, for larger retirement accounts where both tax treatment and beneficiary protection are major concerns, you can consider a specialized IRA Trust designed specifically to address both.
The point is that the beneficiary form is not an administrative afterthought. It is part of your estate plan.
And when retirement accounts represent hundreds of thousands—or even millions—of dollars, checking a box on a beneficiary form without thinking through what happens next can undo many of the protections you spent considerable time building everywhere else in your estate plan.
If one of your concerns is protecting an inheritance from a future son-in-law or daughter-in-law, including the retirement accounts that may represent a substantial part of your estate, visit www.inlawplanning.com.
The goal should not simply be to make sure your family inherits your assets. The goal should be to make sure the inheritance is structured so that the people you intended to benefit are the people who actually benefit from it.