Americans are using a variety of tax-deferred accounts such as 401(k)s and IRAs to save for retirement. Congress currently designed laws so that people must start withdrawing the money when they retire. But, it is not uncommon for many of these accounts to still have significant value at the owner's death. So, as retirement account owners age and die, they will pass a considerable amount of accumulated wealth to loved ones. Many people are unaware that there are numerous options for transferring these accounts to their loved ones. As an estate planning attorney in Austin, Texas, I can help you explore which option is best for your specific situation.
For purposes of this article, we will use "IRA" to refer to a retirement account. This is because many people end up rolling over their 401(k) and other similar retirement accounts into an IRA. They do this to obtain better investment options.
By far, the most common way to leave your IRA at your death is to 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 (i.e., your spouse). Or you can leave a percentage or fraction of your account to multiple beneficiaries, including children, grandchildren, and even charities. When you die, the beneficiaries will be responsible for filing death benefit claims with the account custodian to receive their allocated portion of the IRA account.
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) establishment of an "inherited IRA" account either with the original custodian or by transferring the account to another account custodian as an inherited IRA, or (c) a lump-sum distribution. There may be an option to make periodic payments from the IRA to the beneficiaries. This would depend 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 a claim. Be sure to educate your beneficiaries about these options and encourage them to seek professional advice before making their claims.
Several 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 establishing the trusteed IRA. Typically, however, trusteed IRAs maximize the amount of time over which an IRA trustee must pay out to the beneficiary. Doing so ensures some level of protection against a beneficiary who carelessly spends money. Or it protects a beneficiary who is at risk of divorce, lawsuits, creditors, and predators. A trusteed IRA can also allow you to name successor beneficiaries. That would be relevant if your first beneficiary dies before the account fully distributes.
Please note that not all financial institutions offer trusteed IRAs. Also, trusteed IRAs typically name the financial institution or custodian as the account's trustee. Rather than allowing you to name as trustee a family member or friend you trust to make distribution decisions. Finally, most trusteed IRAs prevent the transfer of an inherited IRA to another financial institution. This locks 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. Trusteed IRAs, standardized documents complying with the laws of most if not all states, leave little room for customization. Therefore, the terms of the trust may not accomplish 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.
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 or IRA trust.
To be clear, estate planning attorneys can use a wide variety of trusts to assist clients in obtaining their objectives. However, most of the time, when someone refers to a "trust," they are referring to a revocable living trust (RLT). Although naming an RLT as the beneficiary of your retirement account is possible, there are some 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 a retirement account 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.
Who or what qualifies as a "designated beneficiary" for tax purposes can make naming your RLT as the beneficiary of a retirement account tricky. Though qualifying an RLT as a designated beneficiary is possible, it can make achieving your other goals very tough. For example, people often name a charity as a remote contingent beneficiary of their RLT (the beneficiary who inherits the trust's money and property if all of the trustmaker's other beneficiaries die first). But that can disqualify the RLT as a designated beneficiary, causing all beneficiaries to have to prematurely withdraw the IRA funds and expose them to increased or accelerated income tax liability.
For these reasons, many IRA account owners should consider using a retirement benefits trust specifically for retirement accounts. Such trusts work well in second marriage situations where one spouse wants to support a current spouse during that spouse's remaining lifetime. But, the predeceased spouse wants to ensure the trustee then pays out the remainder to the children from the first marriage upon the surviving spouse's death. 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 retirement benefits that you leave to a loved one for purposes that you would approve of and exclude people who should not have access to them.
Another option for providing retirement account funds to a loved one is a custodial IRA or a custodial Roth IRA. This option is particularly attractive when you want to leave money to a minor child. With these types of accounts, a parent contributes to an IRA in the name of the child. But lists themselves (or another responsible adult) as the account's custodian. With this option, you can provide tax-deferred growth common for retirement accounts. You also retain some control as the named custodian regarding future contributions to or withdrawals from the account.
Note that the minor can typically access the account upon reaching age eighteen (or, in some states, twenty-one). But, there are generally no penalties when the beneficiary makes an early withdrawal for qualified education purposes.
As you can see, you have various options for leaving retirement benefits to your loved ones. If you need help to more fully understand the implications of these options, don't hesitate to reach out to me. I can help you sort through the pros and cons of each option. Your goals for your beneficiaries will help you determine which options are suitable for you.
(By Appointment Only)
14425 Falcon Head Blvd
Austin, TX 78738