Is your trust listed as the beneficiary on your retirement accounts? Should it be? While many of your assets are likely owned by your trust or list your trust as the beneficiary, your qualified retirement accounts likely list your spouse or children as the beneficiary. Why the difference?
THE DEFAULT DESIGNATION
The One Size Fits All Approach: Most qualified retirement accounts (401(k), IRA, ROTH IRA), list your spouse as the beneficiary followed by your children equally. Generally, it is not difficult to transfer the accounts upon your passing so long as you have a named beneficiary. Most financial institutions will have your beneficiaries fill out a form upon your passing and recommend how your beneficiary should continue owning the asset (rollover to an inherited IRA or cash out). Of course, there are different tax benefits or ramifications depending on the selection.
NAMING A TRUST
Protective Approach: You may also name your trust or a standalone retirement trust as the beneficiary of your qualified retirement accounts. Your attorney should draft your trust knowing it will hold retirement accounts to ensure it contains the proper language and does not cause any undesired tax ramifications. Naming a trust provides additional protections and flexibility that naming an individual under the default designation does not provide. When should you name a trust as a beneficiary instead of an individual?
1. Remarriage: If you want to ensure the assets go to your surviving spouse followed by your children, naming a trust is beneficial. If you pass away and your spouse remarries, the new spouse has a better right to inherit your retirement assets than your children.
2. Creditors: If the surviving spouse has creditor concerns, such as bad debt or gets into a car accident and has a judgement against her, the assets may be used to pay that creditor. Further, if any of your children have bad debt, issues with creditors, judgments against them, or have gone through bankruptcy you should not list them individually as a beneficiary on your retirement accounts.
3. Blended Families: If you or your spouse have a child from a previous relationship or you have separate children, you should be careful naming the surviving spouse as an individual beneficiary. Doing so could effectively disinherit your children (Surviving spouse inherits IRA then passes away. The IRA then goes to her children, not yours).
4. Minor Children: If any of your children are minors, you do not want to list them as a beneficiary on your retirement accounts. Doing so may trigger an unnecessary court proceeding where the court will appoint who is in charge of managing the funds on your children’s behalf and how they should be managed.
5. Money Management Issues: If any of your children are not good at managing their own money and have spendthrift issues you should not name them as a beneficiary, unless you are comfortable with them squandering the money away.
6. Gambling/Alcoholism/Addictions: If any of your children struggle with any addictions, you should not name them as a beneficiary on your retirement accounts. If they inherit outright and free of trust, the funds would likely be used to fuel their addiction.
7. Disability: If any of your children are on disability or may be on disability, you should not name them as a beneficiary as doing so may make them ineligible for needed government programs and benefits.
8. Divorce: If any of your children inherit their assets prior to going through a divorce, their ex-spouse may be entitled to half of the assets. This results in family inheritance going to your child’s ex-spouse instead of your child or grandchildren.
9. Estate Tax: If any of your children have or will have taxable estates, you do not want to name them individually as a beneficiary on your retirement accounts. Doing so may result in up to a 40% tax on the value of the account. If they live in a state with a state estate or inheritance tax you also should consider the potential loss of assets from naming them individually rather than through a trust.
10. Flexibility: At the end of the day, no one has a crystal ball. We do not know if one of your beneficiaries will be in any of these situations when they are set to receive distributions from a retirement plan. Inheriting through a trust gives your trustee the power to protect the assets from these situations and ensure the assets are utilized as you intended for your beneficiaries’ benefit.
Meet Bill and Sandy. Bill and Sandy are in their mid 50’s and have 3 adult children. They were high school sweethearts and have been married for over 30 years. All of their children are great at managing money and have successful careers that do not have high liability concerns. Although Bill and Sandy know divorce rates are high, they think all of their children are in solid marriages and are not concerned about divorce. All of Bill and Sandy’s children and grandchildren are healthy and do not have any disabilities. Bill and Sandy have worked hard their entire life and have built up a modest nest egg. Most of their assets are in investment accounts and real property. They also each have a modest IRA. Bill and Sandy met with their qualified estate planning attorney to plan for their death and disability. They decided to set up a joint living trust to ensure their family does not have to go through the probate process and has a simple roadmap to follow in the event of their death or disability.
How does their attorney recommend they beneficiary their IRAs? Bill and Sandy will likely be well served using the Default Designation for the beneficiary on their qualified accounts: all to surviving spouse followed by their children equally.
Meet Dave and Cindy. Dave and Cindy are in their mid 50’s and have 5 children between the both of them. They do not have any children together. Dave has 3 children from his first marriage and Cindy has 2 children from her first marriage. They have been married for 10 years. Most of their children are good at managing money, but a few of them are impulsive and do not budget well. Dave’s son, Lucas, also has a gambling problem. All of their children have good jobs. Sara, Cindy’s daughter, is even a doctor. Dave and Cindy are also slightly concerned about some of their children’s significant others. They have been through a divorce and know that you do not always see it coming. Sara also has a daughter who may end up on disability. Dave and Cindy own some assets together, but also own individual assets. They have a modest net worth that will keep them comfortable during their retirement years and provide a gift to their children upon their deaths. Dave and Cindy meet with their qualified estate planning attorney and decide to set up separate living trusts with their children inheriting through protective trust shares as well. They want to ensure any inheritance their children receive lasts for a number of years and provides a comfortable retirement. They want their children’s assets protected from creditors and divorce. They also want to ensure that if something happens to one of their children the assets stay in the bloodline.
How does their attorney recommend they beneficiary their IRAs? Dave and Cindy will likely be best served by setting up a standalone retirement trust and naming that trust as the beneficiary or by naming their joint living trust as the beneficiary followed by their children’s individual trust shares.
If Dave and Cindy follow the Default Designation, the following situations may occur:
1. Dave passes away and everything goes to Cindy. When Cindy passes away, the remaining funds go to her 2 children. Dave’s children are effectively disinherited.
2. Dave passes away, Cindy remarries. When Cindy passes away, her new spouse inherits the remaining funds followed by his previous children. Dave and Cindy’s children are both effectively disinherited.
3. Lucas’ share is squandered in 3 months due to his gambling addiction.
4. Sara loses her share to a creditor as she had a judgment against her for malpractice.
5. Sara passes away and her share goes to her daughter. Her daughter is on disability and the inheritance results in her becoming ineligible for disability payments and many of the programs she relies upon to live.
6. Dave’s son receives his share of the estate and then his wife files for divorce the following year. Dave’s son has to give his ex-wife half of his share.
Everyone’s goals and situation is different. Naming a trust (or an individual) may not be the best fit for you. You should speak with a qualified estate planning attorney when deciding what the best fit is to meet your goals and protect your family upon your disability or passing.
All examples given are for illustration purposes only. The people and situations described are not real individuals, but rather represent a scenario to provide guidance on the subject matter. Your attorney will need additional facts and information about your specific situation to give you proper legal advice.