Many estate plans have gone awry due to a misunderstanding of how retirement plan benefits work or failure to account for retirement plan beneficiary designations as part of an overall estate plan.
Because retirement plan assets will, in many cases, be transferred out of your living trust, your retirement accounts and living trust need to be coordinated and reviewed often.
General rules
Pension plans cannot be owned by a trust and are therefore not controlled by a trust document. Instead, upon your death, your retirement plan benefits are payable to the party you designate in a signed (and sometimes notarized) beneficiary designation form.
Pension plans are partly controlled by federal laws, which do not recognize “community ownership.” In the event of a divorce, a state court may divide retirement plans between spouses based on community property laws.
However, the rules are different in the event of the death of the spouse. In the event of the death of one spouse, he or she has no right to designate the beneficiary of the other spouse’s retirement plan.
This is true even if part of the surviving spouse’s retirement plan was considered community property under state law.
The fundamental conflict
You may have developed an estate plan with carefully considered terms for who received your assets, when and on what terms. But none of this will control what happens to your retirement plan benefits.
Only the completed beneficiary designation form will determine who will receive pension plan benefits.
Your trust can say, “I leave all my retirement plans to my children in equal shares” and can even have the plan benefits listed on a schedule of trust assets, but if the beneficiary designation form filed with the custodian of the regime appoints someone else. , that someone else will receive the profits.
For married couples with different beneficiaries – children from different marriages, for example – this can be of particular concern.
The biggest problem for spouses
Let’s take the example of a couple who each have a child from a previous relationship. Assets include an $800,000 home, $1 million in investments, wife’s IRA worth $3 million, and husband’s IRA worth $600,000. Let’s even assume that all of this is community property. The couple creates a trust and places their home and investments into it. IRAs are not trust assets because IRAs must be individually owned.
In the event of a divorce, each spouse would be entitled to half of everything. Each would be left with about $2.7 million in assets and each would be free to create their own estate plan, leaving their $2.7 million in assets to their only child.
On the other hand, in the case of death, the figures are very different. With children from different marriages, it is not uncommon for a trust to be split into two trusts upon the death of the first spouse. These are sometimes called A/B trusts. The surviving spouse’s share of assets is held in trust “A”. The deceased spouse’s share of the trust assets is held in Trust “B” for the benefit of the surviving spouse, but upon the death of the surviving spouse, what remains in Trust B is distributed to the stated beneficiaries, and the surviving spouse cannot don’t change that.
In the example above, if the wife died first, her trust B would hold half of the trust assets (worth $900,000) and, after the husband died, what was left would go to the wife’s child. It’s good.
But if the husband was named as the beneficiary of his wife’s $3 million IRA, there is nothing stopping the husband from naming only his own child (or the dreaded “much younger gold digger”) as the beneficiary of this IRA. It’s now his IRA to do what he wants. The same goes for his $600,000 IRA. So, upon the husband’s death, the wife’s child may receive only what is left in the wife’s B trust, while the husband’s child may end up with the entire A trust and both IRAs. (assuming the gold digger doesn’t get everything).
This is probably not what my wife wanted! The solution may be for each spouse to name their child as the beneficiary of at least part of the IRA, or to name a trust with specific terms for distribution to the spouse and/or children. In both cases, however, there are tax consequences which should be carefully considered in consultation with your professional advisors.
Consent of spouse
If you are married, federal law governing qualified retirement plans (401ks, profit sharing, defined benefit plans, etc.) requires that you obtain your spouse’s consent to designate someone other than your spouse as your beneficiary. This is true even if you accrued some, most, or all of your retirement plan benefits before your marriage. So, if you want your retirement benefits to go to your children or any other party upon your death, make sure you have completed a beneficiary designation form and that your spouse has consented (and make sure consent occurred after the marriage; a prenuptial agreement does not meet this requirement).
IRAs do not have the same federal legal requirements for spousal consent. However, because California is a community property state, an IRA beneficiary designation may also require a spouse’s consent as to the community property portion of the spouse’s account. The consents of the spouses must be notarized.
Trust as beneficiary
A very general “rule” that I hear often is that a trust should never be named as a beneficiary of a retirement plan. From a purely tax perspective this is often true, but it is not always necessary for taxation to wag the dog.
There may be circumstances where it may make sense to name your trust as the beneficiary of your pension plan benefits, and if this is the case, careful consideration should be given to the terms of that trust. If the beneficiary to whom you want to receive retirement plan assets is not someone who should have full control over those assets (for example, a young person, someone receiving government benefits, or a spendthrift), you may want to -consider naming a trust as beneficiary. beneficiary of the retirement plan.
But note that a beneficiary trust can change the rules regarding how and when assets must be distributed from the retirement plan and who (the trust or the individual) pays income taxes. This requires careful planning that is beyond the scope of this article.
Balancing Assets
For example, if you plan to leave your retirement assets to one beneficiary and your trust assets to another, the amount each receives will vary over time and could become very disproportionate. As you make required distributions, the value of your retirement accounts may decrease. On the other hand, if you take these distributions from the plan and don’t spend them, your other assets (i.e. your trust bank accounts) will increase. So, over the years, your beneficiaries may receive significantly different amounts than they would receive in the year you made the decision about who gets what.
Additionally, retirement plan assets (unless it is a Roth IRA) will be subject to income tax as the beneficiary receives them, whereas assets in your trust alive will not be.
Be sure to account for these discrepancies when determining who gets what.
Failure to designate a beneficiary
Failure to complete a beneficiary designation form for retirement plans can also create probate, which is something your trust was intended to avoid. Without a beneficiary designation, the recipient of your retirement plan assets will be determined by the retirement plan document, which provides for a “default” beneficiary. Often, the plan will indicate that the default beneficiary is your “estate.” This means that the pension plan assets will go through a probate process to determine who your legal heirs are, either as set out in your will or intestate. Approval will probably take almost a year, and it’s not cheap.
If retirement plan assets represent a significant portion of your assets, you should be sure to plan for their transfer upon your death as an integral part of your estate plan, not as something independent of it. You worked hard for these assets; they should benefit the people you intended to benefit.
Teresa J. Rhyne is an attorney practicing estate planning and trust administration in Riverside and Paso Robles, California. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild.” You can reach her at Teresa@trlawgroup.net
California Daily Newspapers
