Somewhere in the process of working with your attorney on your estate plan, you should discuss the “designated beneficiaries” named on your IRA’s, 401k’s and any other type of Retirement Account. You may not think you need to pay much attention to this discussion assuming you have that aspect of your estate plan under control.  But it deserves, not requires, your close attention to make sure the plan for the distribution of ALL your assets is complete and carried out as you desire.

Title to your Retirement Account should ALWAYS stay in your name while you are alive.

As you know already, you cannot re-title any of your retirement accounts into the name of your trust while you are alive because, according to the IRS, that would be deemed a taxable withdrawal of all the money from the account.  This is not to be confused with naming a trust as a designated beneficiary on these accounts, which only happens when you die.   However, even though you can name a trust as a beneficiary of your accounts on your death, there are certain complications and may be disadvantages to doing so.  In general, it is better to leave Retirement Accounts outright to the intended beneficiaries unless there is a compelling reason to leave them to a trust for your beneficiaries.

If possible, keep all Retirement Accounts out of your trust or estate when you die too.

On your death, Retirement Accounts are intended to pass automatically (that is without any sort of administration) to the “designated beneficiaries” you name on the “designated beneficiary” page or form of the individual retirement account.  By designating beneficiaries to the account, when you die the funds remaining in the account are distributed directly to the named beneficiary(ies) by the custodian of the account (i.e. the financial institution). Assuming your designated beneficiary(ies) survive you, the accounts will transfer to them without going through probate or even the administration of your trust! Also, you can change the designated beneficiary on your plan any time you want by simply completing a newly designated beneficiary page for the account, which can be done online in many cases.

Why you need to name designated beneficiaries on all of your Retirement Accounts.

If you are a resident of California and you die leaving more than $150,000 in assets in your sole personal name, those assets will have to be probated, unless you have named “designated beneficiaries” on the assets themselves.  Completing a beneficiary designation for your Retirement Account is part of the paperwork done for the specific account and is not part of your trust document. It is particularly important that you complete, and update as needed, the beneficiary designation on each of your retirement accounts, especially when these accounts hold substantial assets which would result in sending them through probate if you die without the beneficiary designations in place.  A probate of these assets would be expensive and will delay completing the administration of your trust too if it is the named beneficiary of your probate estate. This means that your beneficiaries will have to endure both a probate and a trust administration before they receive their full inheritance.  In addition to designating one or more primary beneficiaries on your accounts, you should also designate contingent beneficiaries to take the account in the event that your primary beneficiaries do not survive you.  You should also update these designations as circumstances change in your family, to avoid all unnecessary administration of these accounts except in the very unlikely situation where all of your primary and contingent beneficiaries fail to survive you.  You may also want to give your agent under your Durable Power of Attorney authority to change the beneficiary designations on your Retirement Accounts in the event that you lose capacity, such as if you suffer from Alzheimer’s Disease which can last for many years before you pass away.

When to name a trust as the beneficiary of a Retirement Account.

If the designated beneficiary of a Retirement Account is a minor or is someone who should not otherwise have control or have unrestricted access to the funds in the account, you may want to name a trust to hold the funds from the Retirement Account designated for that person.  However, before doing so, it is imperative that you consult your attorney or CPA about it. As you undoubtedly are aware, Retirement Accounts have significant income tax benefits to you as the account owner. They can also have significant tax benefits for your designated beneficiary(ies) when they are left to the beneficiary(ies) outright.  But, leaving them to a trust for your beneficiaries (even when that trust makes all sorts of sense from a non-tax stand-point), can result in unintended negative tax consequences if the terms of the trust do not follow the strict rules set out in the Internal Revenue Code for them to hold Retirement Accounts. Finally, there are even more rules that the trustee of the trust must know and follow to avoid triggering undesired tax consequences on the Retirement Account later while the account is being administered inside of the trust.  Therefore, you should make sure that you and your successor trustee are consulting with a knowledgeable estate planning attorney when planning for and administering the disposition of funds from a Retirement Account to a trust for one or more of your beneficiaries.

Things to check for in your Retirement Account Documents.

Check your retirement account plan’s “default beneficiary”.  These accounts are paid out according to beneficiary designation forms that you fill out either at the time you open the account or later.  If you fail to name a beneficiary on the account (or no named beneficiary survives you), the plan documents provide for a “default beneficiary”, which normally is either your “estate” (this is the path to probate) or your “heirs” (who are your “legal” next of kin).   Also, you cannot assume your estate will be the default beneficiary. If you have not named a beneficiary on a Qualified Retirement Plan (“QRP”) account, the Retirement Equity Act of 1984 (“REA”) requires that all or part of the account pass to your surviving spouse if you were married for more than a year at the time of your death.  Whether or not REA requires the benefits to be paid to your surviving spouse, your QRP or IRA may provide for a “human” default beneficiary, such as your surviving spouse, children, issue, or next of kin, even if you had otherwise “disinherited” such person in your will or trust or intended for the retirement account to be distributed to your trust so it could pass according to the disposition provisions of your trust.

All retirement plans are different and use different formats for their designated beneficiary pages or forms.  Some of these forms will have boxes you can check so that the share (or all) of the account that you left to a beneficiary who fails to survive you, automatically passes to his/her descendants.  Generally, these boxes will say to your or the deceased beneficiary’s “descendants” or “issue”, and may designate whether the descendants are to receive them “per stirpes” or “per capita”. If the form does not have such a box, you may write the appropriate word after the beneficiary’s name on the form.  If your distribution to the designated beneficiaries is more complicated, you should consult with your attorney for the correct legal language to use in completing the form.

Should you specify “per stirpes” or “per capita”?

The best way to explain the meaning and difference between these terms is through an example.  Let’s assume you name your two children by name as the primary beneficiaries, 50/50, on your Retirement Account.  

If both children are living when you pass away, your account is divided and distributed in two equal shares of 50% each to them respectively.

If one child dies before you pass away and you do not update your beneficiary designation form before you die, here is how the two common default distribution arrangements are applied to the account:

Per Capita Distribution:  100% of the account will go to your surviving child.

Per Stirpes Distribution:  the 50% share that would have gone to your deceased child goes to the deceased child’s children.

You can see where this could lead to unintended results if you were not aware of or did not understand the consequences of the default distribution provision, or did not understand the meaning of the box you checked.  If you are unsure, ask your attorney.

In some cases, neither per stirpes nor per capita may be appropriate for all of your designated beneficiaries named on the account.  In other cases, you may want to include contingent beneficiaries who are not your descendants, such as spouses of your children, your siblings, nieces/nephews, family friends or entities like trusts or charities, or you may want to skip a generation or two and leave the account to grandchildren, great-grandchildren, etc.  In any of these cases, you should consult with your attorney about drafting a customized beneficiary designation to make sure your accounts pass to who you intended whatever happens.

Who should you name as the beneficiary on your Retirement Accounts?

Answering this question requires knowledge of your individual wishes and circumstances.  However, from a purely income tax standpoint, it is usually best to leave your Retirement Account to your spouse (if any) as the primary beneficiary first and then, if your spouse predeceases you, to your children as the contingent beneficiaries.  If you do not have a spouse or do not want to leave the account to him/her, generally it is best to leave it to your children as the primary beneficiaries. Alternatively, if you and your family have sufficient assets to allow you to skip a generation and name younger beneficiaries on the account, you may want to name your grandchildren as beneficiaries of the account as the tax rules allow more of the funds to remain in the account growing “tax-deferred” for much longer.  However, there are limits as to how much you can leave to younger generation individuals before you run into other tax problems, so you should talk with your estate planning attorney or CPA about this possibility.

Another option, assuming you would like to leave something to a tax-exempt charity, would be to name the charity as the designated beneficiary on your Retirement Account.  Doing so will pass the otherwise taxable funds in the account directly to the charity, which as a tax-exempt entity will pay no income tax on them, resulting in more money for the charity.  Beware, however, that naming a charity as one of the beneficiaries on the account may cause tax acceleration on the part of the account passing to your individual beneficiary(ies) named on that account.  This problem can be solved in several ways. Again, you should consult with your estate planning attorney or CPA in advance if you want to include a charity as a beneficiary on your Retirement Account.

IN SUMMARY, while it seems simple to just name the individuals you want as the designated beneficiaries on your retirement accounts, there are lots of ways to make a mistake. You should always bring a copy of the beneficiary designations for your Retirement Accounts to discuss with your estate planning attorney to make sure they are consistent with your overall estate plan and do not cause any unintended tax or other problems for your beneficiaries.