IRA Beneficiaries – Confusion from the Most Recent Law Changes

Over the years, changes in the law have caused changes in the preferred beneficiary designations for your IRA, 401k, 403b, and other qualified plans (“Qualified Plan”). To provide the proper context for this discussion, you should think about your Qualified Plan as a Piggy Bank full of Taxable Income. When the money is distributed out of the Piggy Bank to a beneficiary, the beneficiary must include the money as ordinary income on the beneficiary’s income tax return. Meanwhile the money in the Piggy Bank continues to grow income tax deferred.

To understand where we are now, we need to consider some history. While this is not intended to be a comprehensive, ivory tower explanation of all of the changes to law over time, it is intended to give you an understanding of why we make the suggestions for beneficiaries of your Qualified Plan. This explanation discusses Qualified Plans in terms of primary beneficiary – the first person to benefit from the Qualified Plan at the owner’s death AND contingent beneficiary – the person to benefit from the Qualified Plan if the primary beneficiary does not survive the Qualified Plan owner’s death. The explanation also assumes a family unit of Qualified Plan owner, the owner’s wife and more than one child and total gross assets less than the exemption amount so no estate taxes enter into the discussion.

Years ago, most of us in the estate planning business understood IRAs and other qualified plans were covered under ERISA, which meant that creditors could not reach the assets that were properly contributed to a qualified plan. In those days, the law imposed annual required minimum distributions (“RMD”) at certain times during the owner’s lifetime and to the beneficiary after the owner’s death. The RMDs generally allowed distribution of the Qualified Plan assets over the beneficiary’s lifetime. This lifetime RMD distribution were referred to as Stretch Provisions because it allowed the beneficiary to stretch out the distributions and allow the amount not distributed to continue to grow income tax deferred. In those days, the surviving spouse was the primary beneficiary and adult children who had no issues with wisely investing money were the contingent beneficiaries. Each beneficiary would receive an inherited IRA with the RMD measured over their individual lives. It was a simple but effective way to Stretch the Qualified Plan assets as long as possible.

Then the United States Supreme Court herd a case and ruled that the creditor protections of ERISA extended only to a surviving spouse. Qualified Plan assets left to beneficiaries other than a surviving spouse were subject to the claims of the beneficiary’s creditors. If a Qualified Plan owner wanted to gain asset protection for the non-spouse beneficiaries, the beneficiary needed to be a trust with strong language to protect trust assets from the beneficiary’s creditors. The trustee of the trust could still elect to Stretch the RMDs over the lifetime of the beneficiary but the measuring life for the RMDs was the oldest beneficiary. After that Supreme Court decision, to assure creditor protection for non-spouse beneficiaries, the Qualified Plan beneficiaries were: Primary Beneficiary – Surviving Spouse and Contingent Beneficiaries – The Qualified Plan owner’s revocable living trust. If the owner had no trust, then the children were still named as contingent beneficiaries with hopes no creditor issues would arise.

Then Congress acted. Most recently, the Qualified Plan law changed dramatically. With only a few exceptions, the law no longer allows stretch and RMDs. The Qualified Plan owner and the owner’s spouse can still use RMDs to stretch distributions over their lifetime. In almost all other circumstances, a Qualified Plan beneficiary has no RMD but must receive 100% of the distribution from the Qualified Plan within 10 years. By revoking the RMDs and stretch provisions, each beneficiary must decide when during the 10-year period the beneficiary should receive the beneficiary’s share of the Qualified Plan. If a trust is named as the Qualified Plan beneficiary and the trust has more than one beneficiary, the trust accounting becomes complex. What if one beneficiary wants all of the beneficiary’s share of the Qualified Plan in year one but the other wants none in year one, the trustee must seek a distribution from the Qualified Plan to satisfy the first beneficiary and make the distribution to only one of the beneficiaries. The trust must account for that distribution from the Qualified Plan as ordinary income to the trust and reconcile that with a distribution of income only to one of the trust beneficiaries. That accounting becomes very complex very quickly. For that reason, after the most recent changes to the law, the Primary Beneficiary – Surviving Spouse and Contingent Beneficiaries – the children.

The foregoing describes the history of the generally accepted beneficiary designations under the assumptions described. This complex area has gained more complexity after the last law change. Please feel free to meet with us to discuss your specific circumstances.