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Choosing Beneficiaries for IRAs and 401(k)s: Initial Considerations

Understanding the Basic Rules

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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 Revocable Living Trust, you'll need to consider the following:

Does your Revocable Living Trust contain the appropriate provisions?

Beware: not all Revocable Living Trusts are created equally. If you're 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, or "RMDs," to be stretched out over the lifetimes of your beneficiaries. If the appropriate language isn't in the trust agreement and you designate it as the beneficiary of your IRA, then your beneficiaries will most likely be required to withdraw all of the funds out of the account within 5 years of your death instead of over their own life expectancies.

Does your 401(k) allow for RMDs to be stretched out?

Beware: many 401(k)s, 403(b)s, and other types of employer provided retirement plans invoke the 5 year rule and require that all of the funds left in an account when an employee or former employee dies be withdrawn within 5 years of the employee's death. This is because employers don't want to be in the business of administering an account for a deceased employee for many years into the future. If you still have assets held in a 401(k) or other type of qualified retirement plan with a former employer, then consider rolling the assets over into an IRA. This will offer your beneficiaries the flexibility of stretching RMDs out over their own life expectancies instead of being forced to withdraw all of the funds in 5 years.

Does your 401(k) allow non-spouse beneficiaries the rollover option?

Although the Pension Protection Act of 2006 allows for 401(k)s and other types of employer provided retirement plans to be rolled over into "inherited IRAs" by non-spouse beneficiaries, this option actually needs to be adopted by the employer. Unfortunately the 2006 law didn't require employers to adopt this rollover option, but the Worker, Retiree and Employer Recovery Act of 2008 (or WRERA), which was signed into law by President Bush on December 23, 2008, requires employers to offer this option beginning on January 1, 2010.

Are you concerned about protecting your beneficiaries?

Many states offer significant 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? Recently several court cases have held that once the retirement assets pass to an individual beneficiary, they lose their creditor protection and will be immediately subject to the creditors, including a divorcing spouse, of the individual beneficiary. If you want to provide creditor and divorce protection for your beneficiaries, then consider leaving the retirement plan assets to a lifetime trust or to a special "IRA Trust" for the benefit of the beneficiary 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 won't legally be allowed to 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 upon your state's laws), the beneficiary will gain complete access to and control over the remaining assets. Instead, you should consider designating the separate trust share created for the minor in your Revocable Living Trust as the beneficiary. In addition, you'll need to take into consideration Generation Skipping Transfer Taxes if the beneficiary is a grandchild, or, if the beneficiary isn't related to you, then more than 37 1/2 years younger than you.

Do you have a taxable estate?

If you have a taxable estate and a significant amount of assets in a qualified retirement plan, these assets should be the last place for you to look when figuring out how the estate taxes will be paid. This is because the retirement plan assets won't receive a step up in basis, and so any amount withdrawn from the account will be subject to income taxes. Instead, you should look to cash or life insurance to pay the estate taxes since these assets won't 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 any sales will be minimized.

Are you married and have a taxable estate?

For married couples, in general 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 in to income tax considerations and maximizing options for the beneficiaries named after the surviving spouse dies. In addition, many Revocable Living Trusts don't 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.

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