If you have any of your assets held in a qualified retirement plan, such as a 401(k) or IRA, then before updating your beneficiary designations to compliment the terms of your estate plan, you will need to consider the following factors.
Does Your Revocable Living Trust Contain the Appropriate Provisions?
Beware because not all revocable living trusts contain provisions for accepting retirement accounts as trust assets. If you are considering naming your trust as the beneficiary of your qualified retirement plans, then it must contain specific language that gives your successor Trustee the flexibility needed to make appropriate tax elections and to allow required minimum distributions (RMDs) to be stretched out over the lifetimes of your beneficiaries.
If the appropriate language is not in the trust agreement and you designate it as the beneficiary of your IRA, then your beneficiaries will be required to withdraw all of the funds out of the account in as little as five years after your death instead of over their life expectancies.
Does Your 401(k) Allow for RMDs to Be Stretched Out?
Many 401(k)s, 403(b)s, and other types of employer-provided retirement plans invoke the five-year rule and require that all of the funds left in an account when an employee or former employee dies to be withdrawn within five years after the employee's death. Employers do not want to be in the business of administering an account for the benefit of a deceased employee's beneficiaries for many years into the future.
If you still have assets held in a 401(k) or another type of qualified retirement plan with a former employer and are not concerned about creditor issues, then consider rolling the assets over into an IRA. It will offer your beneficiaries the flexibility of stretching RMDs out over their life expectancies instead of being forced to withdraw all of the funds in as little as five years.
The SECURE Act, part of the spending bills passed by the U.S. Senate on Dec. 19, 2019, and signed into law on Dec. 20 by President Donald Trump, pretty much ended the stretch IRA, and its strategy to shelter inherited income. Under the new law, non-spouse beneficiaries will have to withdraw all the funds in the inherited IRA within 10 years from the death of the original account owner. It applies to IRAs inherited after Dec. 31, 2019.
Are You Concerned About Protecting Your Beneficiaries?
Many states offer creditor protection for assets held in IRAs, and the federal government offers the same type of protection for 401(k)s. But what happens when the account owner dies and the retirement assets are distributed directly to a beneficiary?
In June 2014 the U.S. Supreme Court held that once the retirement assets pass to an individual beneficiary, they lose their creditor protection and will be immediately accessible to the creditors of the beneficiary. If you want to provide creditor and divorce protection for your beneficiaries, then consider leaving the retirement plan assets to a discretionary lifetime trust or a special IRA Trust for the benefit of the beneficiaries instead of outright.
Is Your Intended Beneficiary a Minor?
If the beneficiary of your IRA or 401(k) is a minor when you die, then the beneficiary will not be allowed to legally accept the assets, and so a court-supervised guardianship or conservatorship will need to be established for the minor. Then, when the minor reaches 18 or 21—depending on applicable state law—the beneficiary will gain complete control over the remaining retirement assets.
Instead, you should consider designating the separate share trust created for the minor in your Revocable Living Trust or a separate IRA Trust as the beneficiary. Also, you will need to take into consideration generation-skipping transfer taxes if the beneficiary is a grandchild, or, if the beneficiary is not related to you, then more than 37½ years younger than you.
Do You Have a Taxable Estate?
If you have a taxable estate and a significant amount of your assets are in a qualified retirement plan, then these assets should be the last place for you to look when figuring out how the estate tax bill will be paid. It is because the retirement plan assets will not receive a step-up in basis, and so any amount withdrawn from a qualified account will be subject to income taxes.
Instead, you should look to cash or life insurance to pay the estate tax bill since these assets will not generate any income taxes, or even stocks or real estate since these assets will receive a step-up in basis and so the income tax consequences of a sale will be minimized.
Are You Married and Have a Taxable Estate?
For married couples who cannot rely on portability to maximize their estate tax exemptions, retirement plans should be the last place for them to look to fund the AB Trusts created for the benefit of the surviving spouse in their Revocable Living Trusts. The reasons why are complicated but mainly tie into income tax considerations and maximizing options for the beneficiaries named after the surviving spouse dies.
Also, many revocable living trusts do not contain the appropriate language to administer IRAs left to an A or B Trust. Only you, your spouse, and your estate planning attorney can determine when and if your retirement plans should be named as the primary beneficiaries of the AB Trusts created in your Revocable Living Trust.