Many an estate plan has gone awry due to a misunderstanding of how retirement plan benefits work or a failure to consider retirement plan beneficiary designations as part of an overall estate plan.
Because retirement plan assets will, in many cases, pass outside your living trust, your retirement accounts and your living trust need to be coordinated and reviewed often.
General rules
Retirement plans cannot be “owned” by a trust and thus are not controlled by a trust document. Instead, at your death, your retirement plan benefits are payable to the party you have indicated in a signed (and sometimes notarized) beneficiary designation form.
Retirement plans are in part controlled by federal laws, which do not recognize “community property.” In the event of a divorce, a state court may divide retirement plans between spouses based on community property laws.
However, the rules are different when a spouse dies. If one spouse dies, that spouse does not have any right to designate the beneficiary of the other spouse’s retirement plan.
This is true even if a portion of the surviving spouse’s retirement plan was considered community property under state law.
The basic conflict
You may have completed an estate plan with carefully considered terms for who received your assets, when, and on what terms. But none of that will control what happens to your retirement plan benefits.
Only the properly filled out beneficiary designation form will determine who receives the retirement plan benefits.
Your trust may say, “I leave my retirement plans all to my children in equal shares,” and may even have the plan benefits listed on a schedule of trust assets, but if the beneficiary designation form on file with the plan custodian names someone else, that someone else will receive the benefits.
For married couples with different beneficiaries– children from different marriages, for example—this can be of particular concern.
The bigger problem for spouses
Consider a couple who each have a child from a previous relationship. Assets include a $800,000 home, $1 million in investments, wife’s IRA worth $3 million, and husband’s IRA worth $600,000. Let’s even assume it’s all community property. Couple creates a trust and puts their home and their investments into the trust. The IRAs are not assets of the trust, as IRAs must be owned by individuals.
In the event of a divorce, each spouse would be entitled to half of everything. Each would end up with roughly $2.7 million in assets, and each would be free to create their own estate plan, leaving their $2.7 in assets to their one child.
In the event of a death however, the numbers are quite different. With children from different marriages, it’s not unusual to have a trust split into two trusts at the death of the first spouse. These are sometimes referred to as A/B trusts. The surviving spouse’s share of assets is held in trust “A.” The deceased spouse’s share of trust assets is held in trust “B” for the benefit of the surviving spouse, but upon the death of the surviving spouse, what remains in trust B is distributed to the stated beneficiaries, and the surviving spouse can’t change that.
In the above example, if the wife died first, her B trust would hold her half of the trust assets (worth $900,000), and, after husband’s death, what remained would go to wife’s child. That much is fine.
But if the husband was named as beneficiary of wife’s $3 million IRA, there is nothing that prevents husband from then naming only his own child (or the dreaded “much younger gold digger”) as the beneficiary of that IRA. It’s now his IRA to do as he pleases. The same is true of his $600,000 IRA. Thus, at husband’s death, wife’s child may receive only what remains in wife’s B trust, whereas husband’s child may end up with all of the A trust, and all of both IRAs (assuming the gold digger doesn’t get it all).
This is not likely what wife intended! The solution may be for each spouse to name their child as a beneficiary of at least a portion of the IRA, or to name a trust with specific terms for distribution to spouse and/or children. In both cases, however, there are tax ramifications that need to be carefully considered in consultation with your professional advisors.
Spousal consent
If you are married, Federal law governing qualified retirement plans (401ks, profit-sharing, defined benefit plans, and the like) requires you to obtain the consent of your spouse to name anyone other than your spouse as the beneficiary. This is true even if you accrued some, most, or all your retirement plan benefits prior to your marriage. Thus, if you mean for your retirement benefits to go to your kids or any other party at your death, be sure you’ve completed a beneficiary designation form, and your spouse has consented (and be sure the consent came after the marriage; a pre-nuptial agreement does not satisfy the requirement).
IRAs do not have the same federal law requirement for spousal consents. However, because California is a community property state, an IRA beneficiary designation may also need the consent of a spouse as to the spouse’s community property share of the account. Spousal consents need to be notarized.
Trust as beneficiary
A very general “rule” I often hear is that a trust should never be named as beneficiary of a retirement plan. From a purely tax standpoint, that is often true, but the tax tail doesn’t always need to wag the dog.
There may be circumstances where it makes sense to name your trust as the beneficiary of your retirement plan benefits, and if so, careful attention needs to be paid to the terms of that trust. If the beneficiary you would like to receive the retirement plan assets is not someone who should have full control over those assets–for example, a young person, someone receiving government benefits, or a spendthrift–you may want to consider naming a trust as the beneficiary of the retirement plan.
But note, a trust as a beneficiary may change the rules for how and when the assets must be distributed out of the retirement plan, and who (the trust or the individual) pays the income taxes. This requires careful planning beyond the scope of this article.
Balancing assets
For example, if your plan is to leave your retirement assets to one beneficiary and the assets in your trust to another, the amount each gets will change over time and could become very disproportionate. As you take required distributions, your retirement accounts may decrease in value. On the other hand, if you take those plan distributions and do not spend them, your other assets (i.e., your bank accounts in your trust) will increase. Thus, years down the road, your beneficiaries may receive substantially different amounts than they would have the year you made the decision on who gets what.
In addition, the retirement plan assets (unless it’s a Roth IRA) will be subject to income tax as the beneficiary receives them, whereas the assets in your living trust will not.
Be sure to consider these discrepancies when determining who receives what.
Failure to name a beneficiary
Failure to complete a beneficiary designation form for retirement plans can also create a probate—the very thing your trust was meant to avoid. Without a beneficiary designation, the recipient of your retirement plan assets will be determined by the retirement plan document, which provides for a “default” beneficiary. Often the plan will say the default beneficiary is your “estate.” This means the retirement plan assets will be subject to a probate proceeding to determine who your heirs at law are—either as spelled out in your will or by intestacy. Probate will likely take nearly a year, and it’s not cheap.
If retirement plan assets are a significant portion of your assets, you should be certain to plan for their transfer at your death as an integral part of your estate plan, and not something separate from it. You worked hard for those assets; they should benefit the people you intended to benefit.
Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild.” You can reach her at Teresa@trlawgroup.net
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