Choosing the Wrong Beneficiary of your IRA Can Be Very Costly

By Daniel A. Perry, Esq.

When a client first comes into my office, we normally have a discussion about their family and their general wishes when it comes to distributing their property to their loved ones. In addition, we will also have a discussion about disability and incapacity planning. This discussion always is centered around who to choose in the event that you become incapacitated. However, families rarely believe that estate and legacy planning involves a thorough discussion regarding their IRA.

Many clients that I speak with believe that very little, and no planning should occur when it comes to their IRAs, 401(k)s, 403(b)s, etc. Many people operate on the assumption that these accounts have beneficiaries designated, and therefore, bypass probate and are distributed directly to the named beneficiary … simply, many people believe that no estate and legacy planning is needed with their beneficiary designated accounts.

This is a recipe for disaster! If you have a retirement account valued over $200,000, you need to include IRA planning with your estate and legacy planning.

When You Are Naming Beneficiaries of Your IRA There Are Three Options:

  1. Option 1 – Complete the Beneficiary Designations

This option is simple and easy to complete. Many people will simply name their spouse as the primary and the children as the contingent beneficiaries. However, there are a number of drawbacks. First, the inherited IRA rules apply to the beneficiary. Under these rules, a beneficiary is allowed to stretch the distribution in the form of an Inherited IRA. In this case, the beneficiary’s distributions will be based on the beneficiary’s life expectancy at the time he or she inherits the IRA. In addition, the beneficiary could withdraw all the retirement funds all at once, or they could elect to withdraw all the retirement funds over the course of a five-year period.

Here are some of the disadvantages to naming your children as outright beneficiaries of your IRA:

  • The beneficiary may blow the stretch out
  • The beneficiary may not know about the stretch out
  • The inheritance is not protected from divorce/creditors/predators/lawsuits
  1. Option 2 – Naming a Revocable Living Trust as Contingent Beneficiary

Another option that is available is to name your Revocable Living Trust as beneficiary of your IRA. However, under no circumstances should a Revocable Living Trust be named as beneficiary when you have a living spouse.

When this option is selected, the stretch out will be based on the oldest beneficiary’s life expectancy. Therefore, if you have three children who are beneficiaries of your trust, the stretch out of the IRA will be based on the life expectancy of the oldest beneficiary of the three. However, in order to receive this stretch out treatment, the trust must contain the required pass-through language. If the trust does not have this language, then the beneficiaries will not receive this stretch out.

A downside to naming a Revocable Living Trust as a beneficiary of an IRA is that you are limited to the conduit trust provisions. What this means is that the required minimum distributions flow straight through to the beneficiaries, they are not allowed to accumulate inside of the trust. In addition, as we are limited to the conduit trust provisions, the required minimum distributions do not receive creditor protection.

Typically, this option is beneficial for smaller retirement accounts but are not the best strategy for spendthrift, substance abuse, or special needs beneficiaries. In addition, it is not a great asset protection device for larger retirement accounts.

  1. Option 3 – Stand Alone Retirement Trust

The third and final option is through the use of a Stand-Alone Retirement Trust. This type of strategy has become very popular after the Clark case was handed down by the U.S. Supreme Court, which held that Inherited IRAs are not protected from bankruptcy and creditors.

These are some of the many ways that a Stand-Alone Retirement Trust can benefit of family:

  • Protects the beneficiary from creditors, predators, divorcing spouses, lawsuits, and bankruptcy
  • Protects the principal of the retirement account and can be drafted to protect the required minimum distribution or have a second look opportunity for future required minimum distributions
  • Each beneficiary can stretch for their own life expectancy
  • Can be drafted to be beneficiary controlled at a stated age
  • Great protection for a special needs beneficiary to prevent loss of public benefits

The downside to this type of planning is that you need to ensure that the beneficiary designations stay coordinated with the plan. Also, there is an added cost to set up these types of trusts.

Let’s See the Stand-Alone IRA Trust in Action

Bill has two children, John and Dan. He names John and Dan as equal beneficiaries of his IRA. When Bill dies, the IRA is valued at $900,000 (leaving $450,000 to each child). John doesn’t know about the stretch out or doesn’t care because he wants the money now and withdraws the entire $450,000 share. John is in the 39.6% tax bracket and pays $147,035 in taxes. Dan knows about the stretch out and utilizes it. Dan takes the required minimum distributions from 2018 to 2065 when the Inherited IRA is completely withdrawn. In this scenario, Dan’s total distributions from Bill’s $900,000 IRA is $2,916,313.85!

That looks pretty good and is a major difference! How about we apply the scenario to a Stand-Alone IRA Trust. Let’s say the Stand-Alone IRA Trust states that John and Dan are entitled to income only each year from the trust until age 45, and let’s say that the accumulated withdraws are receiving a return of 4% per year.

At age 83, each beneficiary has seen the Stand-Alone IRA Trust accumulate $2,916,313.85! However, each beneficiary has also seen their required minimum distributions accumulate inside the trust (remember direct beneficiaries and Living Trusts don’t have this option) which could result in the value of the Stand-Alone IRA Trust going even higher.

Bill, with his foresight, was able to engage in planning that left a lasting legacy to his children and grandchildren. Not to mention, the required minimum distributions as well as the principal receive protection from creditors, predators, divorcing spouses, lawsuits, and bankruptcy!

When you have an IRA valued above $200,000, we feel that every family should look into this type of planning in order to protect their family and their children’s inheritance and leave a lasting legacy for their family!

For More Information

If you have questions about Estate Planning and choosing the correct (and necessary) legal protections for you and your family, then please contact our office at (513) 241-0400 or use the contact form available on this website to schedule a time to visit with one of our Estate Planning Attorneys. We look forward to hearing from you!