Your individual retirement account (IRA) is often one of your most valuable, yet least monitored assets. Due to the convenience of automatic contributions coupled with the relative inaccessibility of these assets, many people all but ignore their IRAs, sometimes to the extreme detriment of their families. When planning your legacy, it is important to understand how your IRAs fit into your plan and what steps should be taken to preserve these assets.
- Your Will May Not Govern Your IRA. William and Liv Kennedy were married in 1971. William had a retirement plan through his employer, DuPont, and naturally designated Liv as the sole beneficiary of his plan benefits. As part of their divorce in 1994, Liv waived her rights to William’s retirement, but William neglected to change his beneficiary form before he died in 2001. After William’s death, his executrix and daughter, Kari Kennedy, sought payment of his retirement plan benefits to the estate be distributed to the beneficiaries under his will. The DuPont plan administrator refused and instead disbursed the plan benefits to his ex-wife, Liv, pursuant to William’s beneficiary designation form. As this Supreme Court case, Kennedy v. DuPont Sav. & Inv. Plan, 129 S. Ct. 685 (2009) reflects, it is important to understand that an IRA is a contract between the employer (or plan administrator) and the beneficiary. When a beneficiary designation form is signed, the distribution of your plan is governed solely by that beneficiary designation form and not any other legal documents you may have executed, even a divorce decree or will.
- Always Designate a Contingent Beneficiary. If the beneficiary whom you designate on the plan administrator’s beneficiary designation form predeceases you and you have not named a back-up beneficiary, your IRA will be distributed according to the default terms of the IRA agreement, which vary, but often result in the IRA becoming an asset of your estate. This is not ideal as the IRA will then be subject to probate administration, associated fees, and probable liquidation in order to be distributed pursuant to the terms of your will. In addition, the benefits of extended tax-deferred compounding would be lost without the availability of a stretch IRA scenario – a scenario in which the IRA is inherited by the designated beneficiary who must only take out required minimum distributions (RMDs) based on his or her lifetime, thus allowing the IRA to continue to grow, potentially for generations. For these same reasons, you also should not name your estate as the beneficiary of your IRA.
- Review and Maintain a Copy of Your Signed and Dated Beneficiary Designation Forms. As businesses are acquired, merged, and continue to go paperless, the chances of the plan administrator misplacing or misfiling your beneficiary designation form significantly increase. Accordingly, you should always maintain a current copy of your IRA beneficiary designation form and review it regularly. Anytime you experience a life event such as marriage, divorce, and the birth of a child, you should use that as an opportunity to review your beneficiary designation on file with the IRA plan administrator. As is the case when no back-up beneficiary is named, without a beneficiary designation form on file, the IRA will be distributed according to the terms of the IRA agreement.
- An IRA Cannot Be Paid to a Minor Child. Minors cannot sign paperwork to open an inherited IRA, manage the investments, or request RMDs, thus they cannot be designated beneficiaries of an inherited IRA without also naming an account custodian. If you did name your minor child as the beneficiary of your IRA, the unwanted court proceedings maybe required to appoint a custodian to receive the plan benefits on behalf of your child. For larger accounts, a trust for the benefit of the minor may be named as the beneficiary of the IRA, to be managed by a trustee. If the trust is drafted appropriately to hold an IRA, the inherited IRA will pay RMDs to the trust for distribution to the beneficiary in accordance with the trust’s distribution provisions and the inherited IRA may continue to grow.
- A Trust-Beneficiary Must Qualify as a “See-Through” Trust. The designated beneficiary of an inherited IRA must take RMDs which will effectively liquidate the IRA over time. However, as these RMDs are calculated based on the life expectancy of the designated beneficiary, it is problematic if a trust (with no life expectancy) is designated as the IRA beneficiary. The good news, however, is that under certain circumstances, a “see-through” trust will allow the trust’s beneficiary to be treated as the designated beneficiary for the purpose of stretching the RMDs over the beneficiary’s lifetime. To qualify, a trust must meet four specific requirements as stipulated in Treasury Regulation 1.401(a)(9)-4, Q&A-5:
- The trust must be valid under state law;
- The trust must be irrevocable, or by its terms become irrevocable upon the death of the original IRA owner;
- The trust’s underlying beneficiaries must all be identifiable as being eligible to be designated as beneficiaries themselves; and
- copy of the trust documentation must be provided to the plan administrator by Oct. 31 of the year following the IRA owner’s death.
If the four requirements listed above are met, a trust can qualify as a designated beneficiary, and the RMDs can be stretched based upon the life expectancy of the oldest beneficiary of the trust.