March 14, 2011

Making Smart IRA Beneficiary Designations

In 2010 a hot topic in the field of IRAs and retirement planning was the conversion of traditional IRAs into Roth IRAs. While the conversion has proven to be financially advantageous in some cases, the heightened discussion surrounding IRAs has reminded us of the importance of discussing appropriate beneficiary designations for the purposes of creating an integrated estate plan. It cannot be emphasized enough that an IRA passes by beneficiary designation and not by the provisions of one’s Will. Therefore, separate attention should be given to IRAs, and other non-probate assets, to ensure that they pass to one’s desired beneficiaries. The IRA Basics  The establishment of an IRA account is not an irrevocable act. However, the penalties associated with withdrawing monies from the account before age 59 ½ can be steep. After an account holder has reached the age of 59 ½ years, withdrawals from an IRA account become penalty free. Under a traditional IRA, the most important item for discussion is the distribution requirement. The “required minimum distribution” (RMD) is the amount that must be annually withdrawn from an IRA account after the account holder has reached the age of 70 ½ years. The RMD is calculated based on the account’s balance in relation to the holder’s life expectancy, and as its name implies, is a floor, not a ceiling for distributions. As such, after attaining the age of 70 ½ years, an account holder can withdraw amounts in excess of the RMD for that year, but no less. Additionally, any distribution from a traditional IRA account, including any RMD, is taxable to the recipient as income. The main differences between a traditional IRA and a Roth IRA, which makes the Roth particularly attractive, are that: (1) after attaining the age of 59 ½, withdrawals are tax free and (2) there are no RMDs. Thus, a Roth IRA provides for the continued growth of the account, free of tax, after the account’s establishment.[1] However, unlike a traditional IRA, contributions to a Roth IRA are not tax deductible. Distribution Periods  Upon the IRA account owner’s death, the default distribution period for an IRA account is the “five-year rule.” This rule mandates that all of an IRA’s asset must be distributed within five years of the account holder’s death. This distribution period is applicable when the account holder dies without ever having taken a distribution from his or her account. There is an inherent problem for the beneficiaries of an IRA account where the “five-year rule” is triggered. The application of the “five-year rule” means that there is no extended income tax deferral for the beneficiaries of a traditional IRA, as all of the account’s value must be realized as income within a five-year period. In contrast to the “five-year rule,” are distributions that result in the maximum income tax deferral for the beneficiary of an IRA account. This occurs when a named beneficiary inherits the account after the participant has passed away. These distributions are referred to as “stretch” distributions, which allow the IRA’s funds to be withdrawn over the beneficiary’s life expectancy.[2] Furthermore, the beneficiary need only withdraw the RMD every year, so funds can continue to accumulate tax-free within the account. What happens when there is no “designated beneficiary”?  As noted above, the “five-year rule” is the default distribution rule after the death of the account holder. As such, the “five-year rule” applies and mandates the distribution of the entire account within five years of the participant’s death when an account does not have a qualifying designated beneficiary. In order properly designate a beneficiary for the purposes of an IRA, the general rule is that the beneficiary must be an individual. Furthermore, the beneficiary must be named in the IRA paperwork. The designation of an individual in the account holder’s Last Will and Testament will not satisfy the qualified designated beneficiary requirement. There are some exceptions to the requirement that the beneficiary of an IRA be an “individual.” For example, if an account holder designates a trust as the beneficiary of his IRA, for the purposes of the designated beneficiary requirement, the beneficiary or beneficiaries of the trust are considered to be the designated beneficiaries, and will not trigger the “five-year rule.” It should be noted, however, that such a trust must only have individuals as beneficiaries. The designation of a charity or private foundation among the class of trust beneficiaries will trigger the “five-year rule.” Which “individuals” can be beneficiaries?  Assuming that a participant’s spouse is still living, he or she will likely be the designated beneficiary of the IRA account. Where the spouse is the designated beneficiary he or she may choose to either: (1) take the annual RMD using the deceased spouse’s life expectancy or (2) roll the IRA account into his or her own IRA account, where his or her life is the measuring life for RMD purposes. However, even where an account holder’s spouse is still alive, he or she need not necessarily be the designated beneficiary of the spouse’s IRA. It should be noted that this is one key difference between IRA accounts, 401(k) plans, and other employee sponsored retirement plans.[3] In fact, it is possible for an IRA account holder to designate multiple beneficiaries, only one of which is his or her spouse. However, participants should be wary of this scenario, as the options available to the surviving spouse described above, will no longer be available if he or she is merely a member of a group of beneficiaries. Where there is a single designated beneficiary who is not the surviving spouse, then that beneficiary will be required to take annual RMDs in accordance with his or her life expectancy. Two problems arise where multiple beneficiaries are designated on the same account. First, operating under the assumption that each of the named beneficiaries is of a different age, which beneficiary’s age will govern the RMDs? Under the Treasury Regulations, the oldest designated beneficiary’s life expectancy will be used to calculate the distributions. This means that if one of the beneficiaries is older than the others, the younger beneficiaries will not be able to “stretch” their distributions to the same extent as if they were the only beneficiaries. Secondly, even with one or two qualified designated beneficiaries, an account may still fall prey to the “five-year rule.” In the event that an account has several designated beneficiaries, one of which is not a qualified beneficiary (such as a charity as indicated previously), then all of the beneficiary designations will be deemed to have failed, thus triggering the application of the “five-year rule.” As a post-mortem solution to the problems discussed above, beneficiaries are entitled to split a single inherited IRA account into individual accounts, so long as the split occurs no later than the end of the year following the year in which the original account holder passed away. Where an IRA is divided into separate accounts, the RMDs are calculated only with reference to that singular beneficiary’s life expectancy. This conversion option is clearly an important tool, as it allows younger beneficiaries the opportunity to “stretch” their distributions, and make their own investment decisions, independent of the ages and opinions of the other beneficiaries named on the inherited account. The use of trusts to protect IRA assets As with all planning documents, the use of a trust allows an IRA account holder some post-mortem control over the moneys he or she worked to accumulate over his or her lifetime. For example, a trust is an effective planning tool for an IRA account where there is a second marriage involved. Where husband and wife have each been married before, and each have children from their first marriage, a trust can be used to ensure that the surviving spouse can benefit from the moneys in his or her spouse’s IRA during his or her lifetime, while allowing the deceased participant’s spouse control over the ultimate beneficiaries of the account after the surviving spouse’s death. As such, an IRA trust can be used to ensure that a surviving spouse cannot disinherit the children of the original account holder, who are not his or her own separate children. As discussed above, only individuals can be named as beneficiaries of the IRA accounts. However, there is an exception to this general rule, whereby a participant may name a trust as the beneficiary of his or her IRA. The use of a trust allows an IRA participant to control the proceeds of his or her IRA after death, while also allowing for the “stretching” of distributions. However, it should be noted that the designation of a trust causes the loss of the benefit of the spousal rollover, even if the surviving spouse is the sole beneficiary of the trust. Conclusion  As briefly described in this article, there are multiple issues to be aware of when designating a beneficiary for your IRA account. Although an IRA designation need not be executed in the same manner as one’s Will, the amount of forethought which should go into the designation should be tantamount to the effort expended in planning for the disposition of one’s probate assets. Since beneficiary designations can be changed as frequently as a participant may like, it is important to examine your beneficiary designations to ensure not only that they are qualified, but also that they fit into the estate plan that you and your attorney have worked hard to create to meet your personal goals. Should you need assistance or have questions, please contact Judson M. Stein, Esq. of our Trusts and Estates Practice Group at (973) 533-077 or you can e-mail -------------------------------------------------------------------------------- [1] It should be noted that when a taxpayer converts a traditional IRA into a Roth IRA, the taxpayer must pay income taxes on the tax-deductible contributions made to the traditional IRA, and the tax-free growth within. However, if the conversion took place in 2010, the income tax to be paid can be spread over 2011 and 2012. [2] If the beneficiary is the account owner’s surviving spouse, the RMDs can be stretched even further. [3] Under ERISA, which governs any defined benefit plan, including 401(k) plans, if the participant is married, then benefits must be paid either in as a qualified joint and survivor annuity or a qualified pre-retirement survivor annuity. Although participants have the right to waive these annuities with written spousal consent, the default rule of such plans does not allow for a beneficiary designation in favor of anyone other than the surviving spouse (unless there is written spousal consent) where the participant was married at death. IRAs are excepted from these requirements.