How to Incorporate Your Retirement Accounts in your Estate Planning

Incorporate Your Retirement Accounts in your Estate Planning

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. And while the laws are currently designed so that people must start withdrawing the money when they retire, it is not uncommon for many of these accounts to still have significant value when the owner dies. What most people don’t know is that there are numerous options for transferring these types of accounts to their loved ones.

(For this article, we’re going to use the term “IRA” to refer to retirement accounts, because many people with 401(k)’s and similar accounts end up rolling them into an IRA for greater investment options)

Option 1: Outright Distributions using 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. If you choose this option, the beneficiaries will be responsible for filing death benefit claims with the account custodian to receive their portion of the IRA account after you die.

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) creation of an “inherited IRA” account either with the original custodian or by transferring the account to another account custodian, or (c) taking 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 when it comes time for them to inherit your IRA, before making their claims.

Option 2: Trusteed IRA

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.

But not all financial institutions offer trusteed IRAs. Also, for those institutions that do offer them, they may have some downsides. For example, it’s fairly common that trusteed IRAs will 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. Another limitation of trusteed IRAs is that most prevent you from transferring the 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.

Option 3: Custom Retirement Benefits Trust

Another option for IRA account owners whose beneficiaries have specific needs or circumstances is a customized retirement benefits trust, sometimes called a standalone retirement trust (SRT) or IRA trust.

Be careful though – as some attorneys that offer estate planning may really only provide you with a standard trust, which we refer to as a revocable living trust (RLT). An RLT is a great planning tool for certain objectives (such as avoiding probate), 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 an IRA payable to an RLT (as beneficiary) fair game 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 contingent beneficiary of their RLT. But doing so 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 standalone retirement benefits trust, which is specifically for retirement accounts. Such trusts work especially 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 the IRA you leave to a loved one is used for only those things that you would approve of and are protected from people who should not have access to them.

Option 4: Custodial IRA

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 twenty-one (it varies by state). One of the benefits of these types of accounts is that there are typically no penalties for early withdrawals made for qualified education purposes.

What’s the Best Option for You?

As you can see, you have a variety of options for leaving retirement benefits to your loved ones. At Beaupre Law, we take a holistic approach to your life and legacy planning in which we’ll work closely with your financial advisors, to help determine which options are best for you. Often, this starts with a detailed understanding of the goals that you’d like to accomplish for your beneficiaries. Contact Beaupre Law to learn more!