Retirement Plan Beneficiary Designations: The good, the bad and the ugly!

Individuals may often have a complex estate plan, but failure to properly address a retirement plan beneficiary designation can cause havoc. Regardless of what a client’s estate plan may say, the beneficiary designation under the client’s IRA governs. For many clients, their largest asset is their retirement plan. IRAs in particular require special attention because they are subject to both estate taxes and income taxes. Listed below is a summary of “The Good, The Bad and The Ugly” issues to be mindful of as you navigate through the complex rules that govern retirement plans and beneficiary designations. 

I.  Black Letter Law for Timing of Post Mortem Distributions

Distribution of Assets when Participant dies BEFORE age 70 ½: Distributed

• within 5 years or
• over the life expectancy of the designated beneficiary. Treas. Reg. § 1.401(a)(9)-3.

THE GOOD: If the designated beneficiary is the participant’s spouse, there is increased flexibility and the surviving spouse may roll over to his or her own IRA. Note: Where the distribution is made by reason of the death of the participant, distributions from the participant’s account to the surviving spouse under age 59½ are NOT subject to the 10 percent early distribution tax under IRC § 72(t). PLR 9418034 (February 10, 1994).

Distribution of Assets when Participant dies AFTER age 70 ½: Distributed over the longer of

• the remaining life expectancy of the participant; or
• the life expectancy of the designated beneficiary.  Treas. Reg. § 1.401(a)(9)-5.
• Note:  If the designated beneficiary is the participant’s spouse – increased flexibility.

II.  Definition of “Designated Beneficiary” and Trust Complications

Designated Beneficiary: Individual identified as a beneficiary of the Plan and is determined as of September 30 following the year of the participant’s death. Treas. Reg. §1.401(a)(9)-4.

• An estate does NOT qualify
• A charitable organization does NOT qualify
• A living trust MAY qualify

When will a trust qualify as a “designated beneficiary?” See Treas. Reg. § 1.401(a)(9)-4.

• Trust must be valid pursuant to state law and irrevocable (upon death of participant is sufficient)
• Only individuals may be beneficiaries and beneficiaries must be identifiable
• By October 31 of the calendar year following the participant’s death, trustee must provide to the administrator either (i) a copy of the trust or (ii) a list of all beneficiaries of the trust

THE BAD: Unless the trust includes specific “Stretch IRA Trust” or “Conduit Trust” language and the beneficiary designations are properly updated, even if the trust is treated as a “designated beneficiary,” the OLDEST trust beneficiary is used for purposes of determining the distribution period for the minimum required distribution. Treas Reg § 1.401(a)(9)-4.

• Look through the trust to the life expectancies of ALL beneficiaries – including contingent beneficiaries and identify the beneficiary with the shortest life expectancy (oldest beneficiary). Treas. Reg. § 1.401(a)(9)-5, Q&A 7(c); See also PLR 200228025 (April 18, 2002).

THE UGLY: If a traditional living trust is the beneficiary…there is the potential for increased complications!

• Marital Trust Problem: If retirement assets are used to fund the marital trust (a.k.a QTIP Trust), issues arise if a charity is an ultimate beneficiary, and excess income taxes may be incurred. The QTIP Trust may receive a required minimum distribution from the IRA that is greater than the income earned by the IRA and the income will often be taxed at the maximum federal income tax rate.
• Credit Shelter Trust: Often the surviving spouse is the applicable measuring life for purposes of the minimum required distribution. The income tax liability associated with the minimum required distribution depletes the assets of the credit shelter trust. But, if assets are distributed to the surviving spouse, this is counter to the purpose of the credit shelter trust.
• These issues can be avoided if (i) your existing living trust is amended to include “Stretch IRA Trust” or “Conduit Trust” language which would enable for maximum income tax planning; and (ii) your beneficiary designations are properly updated to correspond with those changes.

III.  Planning Advice

• Generally, from a tax perspective and in an effort to ease administrative burdens, it is best to appoint an individual beneficiary (vs. a trust);  name several contingent beneficiaries so that “disclaimers” / post-mortem planning is an option.
• If a client insists on using a trust, consider drafting a 401k trust (also known as a “Stretch IRA Trust” or a “Conduit Trust”), a trust customized to ONLY hold the retirement plan beneficiary designations and circumvent some of the traditional problems associated with naming a trust as a designated beneficiary.
• If beneficiary designation is a living trust, include customized language that allows the trustee to accelerate the distribution to any disqualified beneficiary before the September 30 after grantor’s death, or try to have “bad beneficiaries” disclaim interest before September 30 date – not always an option.

We would be happy to discuss your particular circumstances and review your existing estate planning documents and beneficiary designations to ensure effective estate planning and income tax planning.

Client Alert authored by: Lindsey Paige Markus