In response to my recent estate planning newsletter, one of my clients, who is also a financial advisor, emailed me to say, "thank your for saying living trusts should not be the beneficiaries of retirement plans. Too many estate planning attorneys want the living trust as beneficiary for a 401k. It just jams things up."
I agree.
In this article, I will provide an overview of what we generally recommend to our clients about naming beneficiaries of their retirement plans.
By retirement plans, I mean 401ks, IRAs, 403bs, and 457s, and the like.
Retirement plans are not brokerage accounts. Brokerage accounts are sometimes called taxable accounts or non-qualified accounts. For our purposes, we will refer to them as "brokerage accounts."
Brokerage accounts are very different than retirement plans, especially in estate planning.
Brokerage accounts will go through probate if the total value of the accounts and bank accounts exceeds the California probate threshold of $184,500.
To avoid probate, brokerage accounts should be titled in the name of the living trust.
Joe and Mary Perez should title their brokerage accounts as "Joseph Perez and Mary Perez, Trustees of the Joseph and Mary Perez Family Trust (or whatever is the name of their trust).
Titling the brokerage accounts in the living trust will not only avoid probate, but it will also authorize the successor trustee to manage the accounts if the owner becomes incapacitated or passes away.
Some brokerage accounts will allow the owner to name transfer-on-death beneficiaries on the accounts. This may be okay if you don't have a living trust. But if you have a living trust, we recommend naming it as the owner of the brokerage accounts; then you don't need to name a beneficiary.
Also, as stated above, if the living trust is the account owner, the successor trustee can manage the account if needed. Financial institutions tend to favor working with the successor trustee of a living trust more than an agent of a durable power of attorney.
Retirement accounts are more complicated than brokerage accounts because distributions are taxed as income. Distributions of brokerage accounts are not taxed as income.
When the owner of a retirement plan dies, the designated beneficiary (the person the owner named as beneficiary on the financial institution's beneficiary designation form) can either cash out or create an "inherited IRA".
If the designated beneficiary cashes out, she will have to pay income taxes on her share of the retirement plan. If she creates an inherited IRA, she can spread out the distributions over ten years so the tax hit is incremental over time and not all at once.
If the retirement plan owner has named a designated beneficiary, then when he dies, the retirement plan will not go through probate. The beneficiary will contact the financial institution and instruct it to either make a payout or set up an inherited IRA.
BTW. If the surviving spouse is the beneficiary, the rules are different. She can roll-over the retirement plan, and it becomes her IRA, not subject to the ten-year inherited IRA rule. But she will have to take required minimum distributions over her lifetime.
If one or more individuals are named as designated beneficiaries, the distribution at death is straightforward—usually an easy process with the financial institution.
However, if the retirement plan owner has named his living trust as the designated beneficiary, it gets more complicated, or as my client said, "it gets jammed up." The financial institution's legal compliance department will need to review the trust and confirm that it meets the requirements of a "see-through trust" (a valid trust with individuals as beneficiaries that becomes irrevocable upon the owner's death), which takes time and is a big hassle for the successor trustee and the trust beneficiaries.
To avoid the jam-up, we recommend our clients name individuals, not their living trust, as their designated beneficiary. And then, of course, also name individuals as contingent beneficiaries.
There is an exception to this recommendation. If our client has young children, we recommend naming the living trust as the designated beneficiary rather than naming the children. The living trust has a successor trustee who can manage the IRA distributions for the children. But when the children get older, we recommend naming them directly as the beneficiaries instead of the living trust.
The retirement plan owner can also name a charity as the designated beneficiary. If they intend to leave a portion of their estate to charity, then giving the charity the retirement plan is more tax-efficient than giving the charity a share of the trust assets. Individuals have to pay income tax on retirement plan distributions. But because they are non-profits, charities don't have to pay income taxes on retirement plan distributions, so 100% of the retirement plan can go towards the charity's philanthropic effort.
One of the fundamental principles we teach our clients is to think through the finish line. In other words, how you design your living trust and how you name your retirement plan beneficiaries will determine how easy or difficult the trust administration will be when you pass away. Our overriding principle is to keep it simple. The simpler the plan, the more likely your wishes will be executed. Complicated plans will be more difficult for your successor trustee and the financial institution to execute.
Sometimes an older parent whose spouse has died fails to update the beneficiaries on his retirement plans, and this could result in probate:
Husband named his wife as primary beneficiary of his retirement plan, but he failed to name a contingent beneficiary. When his wife died, he no longer had a beneficiary. Then when he died, since there was no designated beneficiary, the retirement plan had to go through probate.
If there is no designated beneficiary, the retirement plan most likely goes through probate. Therefore, the beneficiary designations on retirement plans must be kept up to date.
Having a conscientious financial advisor who knows you and your goals and who reviews your accounts with you regularly is very valuable. Rarely do we see retirement plans lapse into probate when there is a good financial advisor. Often, it's the DIY retirement plans that lack a designated beneficiary end up in probate.
Here are our general recommendations for naming designated beneficiaries for your retirement plans. Note that your unique situation may not necessarily fit this general recommendation.