With uncertainty being our new normal, it is even more important that we all take time to get our affairs in order. We are all sailing into unchartered territory, and each of our ships needs to be as shipshape as possible.
One area that is often overlooked is making sure your retirement plan beneficiary designation is up to date. A lot of us sign the form when our plan is established but never think about changing it. This can create issues if our benefits wind up being disbursed to the wrong persons, or even worse, if they are disbursed to the right persons but are unprotected against creditors and divorce.
You can typically designate that your retirement benefits be paid outright to one or more individuals at your death. You can also designate contingent beneficiaries if your primary beneficiary should predecease you. Most commonly, you see the surviving spouse designated as the primary beneficiary with children or grandchildren listed as the contingent beneficiaries. This is the area I want to explore with you since inherited retirement benefits payable outright to children or grandchildren have no protection against creditors and divorce (unlike benefits payable to surviving spouses which typically are protected).
If you want to list your children or grandchildren as either your primary or contingent beneficiaries, then you have to either leave the benefits to them outright or in a trust. If you leave the benefits to them outright, then those benefits are at risk in the event of a divorce or creditor’s claim. This could result in half the benefits or more being lost. Only a trust will protect the benefits against this risk.
Until this year, you could name a trust for your children or grandchildren that would last for their lifetimes and automatically distribute out the retirement benefits to them over that period of time. This was a great plan since the retirement benefits were paid out over a long period of time (“stretched out”), which allowed for maximum income tax free growth in the retirement account and lifetime asset protection. Congress changed the law this year to require that these retirement benefits be fully distributed out of the retirement account at the end of ten years from your death. This new law was passed primarily to accelerate the payment of income taxes on the retirement benefits (end of ten years versus the lifetimes of children or grandchildren). While there are a few exceptions for minors, the disabled, or the chronically ill, this ten year rule applies to most all beneficiaries other than surviving spouses.
Accordingly, you want to name a trust to protect your retirement benefits for your children or grandchildren against divorce and creditors. What are your choices? Well, you could set up a trust that lasts for the ten year period and then has to terminate. Probably not worth setting up just for ten years of protection. If you set up a trust that lasts for longer than ten years, then you get the long-term protection but at a cost of a 37% income tax on the trust’s income (and all of the retirement benefits would be considered income) after about $13,000 of trust income each year.
Happily, there is a win-win option. We can create a trust that provides long-term protection but taxes the income at the tax rate of your child or grandchild (where the 37% tax rate doesn’t apply until around $510,000 for a single person or around $612,000 for a married person). That is a huge tax savings when compared to the 37% trust tax rate on income over around $13,000. However, this tax smart way of handling your retirement benefits combined with long term protection has to be set up before you die. This is why it is so important to take time to address and deal with things like this now, and not put them off. If we have learned anything, it is that stuff happens unexpectedly, and we need to be ready.