Beneficiary Designations For 401(k)s, IRAs and Other Non Probate Assets

Beneficiary Designations For 401(k)s, IRAs and Other Non Probate Assets Dani Smith 12221 Merit Drive, Suite 825 Dallas, Texas 75251 (469) 375 4537 dani@danismithlaw.com

Beneficiary Designations For Non Probate Assets Beneficiary designations on non probate assets will control absent proof of a breach of fiduciary duty, undue influence, fraud, or lack of capacity. See generally, In re Estate of Abernethy, 390 S.W.3d 431 (Tex. App. El Paso 2012, no pet.). It is important to coordinate beneficiary designations for insurance and qualified plans with the estate plan. Understanding the basic minimum distribution rules for qualified plans is necessary to understand the consequences of certain beneficiary designations. 2

401(k)s and IRAs: Permissible Distributions Permissible Distributions from Traditional 401(k)s and IRAs: Distributions from a traditional 401(k) and IRA may begin at age 59 ½ without penalty. There is no restriction on how much can be withdrawn after attaining age 59 ½. Distributions taken before attaining age 59 ½ are subject to a 10% excise tax (subject to exceptions set forth in IRC 72(t)). 3

401(k)s and IRAs: Permissible Distributions Permissible Distributions from Roth IRAs: Qualified distributions from a Roth IRA may begin after a five year waiting period and a triggering event occurs. Generally, the fiveyear period begins on January 1 of the first year for which a contribution was made to any Roth IRA. Further contributions do not start a new five year Period. The most common triggering events are attaining age 59 ½, death or disability. Certain qualified special purpose distributions for certain purchases for first homes also exist under 408A(d)(2)(A)(iv), (5); 72(t)(2)(F), (8). There is no restriction on how much can be withdrawn for Qualified Distributions. 4

401(k)s and IRAs: Permissible Distributions Permissible Distributions from Roth IRAs (Cont d): Distributions taken before the five year Period and the occurrence of a triggering event are taxed to the extent the nonqualified distribution consists of earnings in excess of contributions. Contributions are deemed to come out first under the ordering rules. Thus, a participant can still withdraw money income tax free, up to the amount the participant contributed, even if the participant does not meet the requirements for a qualified distribution. 5

401(k)s and IRAs: Permissible Distributions Permissible Distributions from Designated Roth Accounts (Held inside a 401(k), 403(b) or 457(b) Plan): Qualified distributions from a Designated Roth Account may begin after a five year waiting period and a triggering event occurs. Generally, the five year period begins on January 1 of the first year for which a contribution was made to that particular plan. 402(A)(d)(2)(B)(i). The most common triggering events are attaining age 59 ½, death or disability. The qualified special purpose distributions for certain home purchases do not apply to a Designated Roth Account. 402A(d)(2)(A). There is no restriction on how much can be withdrawn for Qualified Distributions. 6

401(k)s and IRAs: Permissible Distributions Permissible Distributions from Designated Roth Accounts Held inside a 401(k), 403(b) or 457(b) Plan)(Cont d): Distributions taken before the five year period and the occurrence of a triggering event are taxed to the extent the nonqualified distribution consists of earnings in excess of contributions. Unlike with a Roth IRA, contributions are not deemed to come out first. Instead, any distribution carries out proportionate amounts of the participant s basis and earnings. Thus, every nonqualified distribution from a designated Roth Account will be partly taxable unless there has been no appreciation or the earnings portion is rolled over. 7

Minimum Distribution Rules Required Distributions: 401(k): The plan participant must begin taking distributions by April 1 of the calendar year following the year in which the plan participant reaches age 70 ½ or retires (referred to as the Required Beginning Date RBD ). Reg. 1.408 8. Traditional IRA: The RBD is April 1 of the calendar year following the year the participant reaches age 70 ½ regardless of whether the participant is retired. 408(a)(6). 8

Minimum Distribution Rules Required Distributions (Cont d): Roth IRA: There are no required distributions from Roth IRA s during the plan participant s lifetime. After the participant s death, however, the minimum distribution rules do apply to Roth IRAs. Because there is no RBD for the participant, the post death minimum distribution rules will always be applied as thought the Roth IRA owner died before his RBD. Reg. 1.408A 6, A 14(b). (Note: a designated Roth account inside a 401(k), 403(b) or 457(b) is subject to the required minimum distribution rules). 9

Minimum Distribution Rules Required Distributions (Cont d): Distributions from a Roth IRA cannot be used to fulfill a distribution requirement with respect to any other kind of IRA. Reg. 1.408A 6, A 15. Beginning in the first year that a minimum distribution is required from a traditional qualified plan or IRA, such plan or IRA cannot be converted to a Roth IRA until after the MRD for the year of the conversion has been distributed out of the traditional plan or IRA. Reg. 1.408A 4, A 6(a), (b). The penalty for failure to distribute the minimum required amount is 50% of the short fall. IRC 4974. 10

Minimum Distribution Rules Required Distributions (Cont d): There is no required distribution for active employees owning not more than 5% of the employer who are still working. This exception does not apply to IRA s or 403(b) plans. Distributions are taxed to the recipient in the year of receipt. 11

Minimum Distribution Rules Amount of Distribution: The annual minimum distribution is determined by using Uniform Life Expectancy Table based on participant s age and a presumed beneficiary 10 years younger in age. Reg. 1.401(a)(9) 5. The actual age of the presumed beneficiary or whether beneficiary is individual Trust or charity is irrelevant. Exception: If the beneficiary is the participant s spouse and the spouse is more than 10 years younger than the participant, the calculation table may incorporate the actual age of the spouse. Reg..401(a)(9) 4. 12

Minimum Distributions After Death of Participant The commencement of the required minimum distributions depends upon: Whether the plan participant died before or after his or her RBD; Whether the beneficiary is a spouse; Whether there is a Designated Beneficiary which must be a Natural Person or a Qualifying Trust. Entities such as estates, charities, corporations and partnerships do not qualify as Designated Beneficiaries The determination of Successor Beneficiaries is made as of Sept. 30 of calendar year following death. 13

Presence of Nonqualified Designated Beneficiary Plan Participant Dies Before Reaching His or Her RBD: Five Year Rule: All funds must be withdrawn by December 31 of the fifth calendar year following the calendar year of Account Owner s death. Plan Participant Dies After Reaching His or Her RBD: Successor Beneficiaries must take required minimum distributions using participant s Life Expectancy (Using Single Life Table NOT Uniform Lifetime Table) for participant s attained age in the calendar year following the calendar year of death and each subsequent year s applicable divisor is equal to prior years minus one. 14

Presence of Nonqualified Designated Beneficiary General Rule: Never name the estate as the beneficiary. It is virtually impossible to eliminate the negative income tax consequences unless the surviving spouse is the fiduciary and beneficiary. Strategies: Cash out Non qualified successor designated beneficiaries. Charitable Beneficiaries: Plan proceeds paid to a charity will not be subject to income tax or estate tax. Participants who intend to benefit one or more charities should consider naming a charity as a beneficiary to receive a separate share of the plan. Note: It is not usually desirable to name a charity as a beneficiary of a Roth IRA or Designated Roth Account because those assets are generally passing income tax free. 15

Naming the Spouse as Beneficiary A full marital deduction is available for estate tax purposes if a spouse is named as the beneficiary. ERISA requires consent of spouse to name a beneficiary other than the spouse. This will not apply to IRAs. 9.302 of the Family Code provides that a pre divorce designation of an ex spouse as beneficiary under an individual retirement account or other employer plan or financial plan will not be effective unless required by the divorce decree or a re designation is made or the ex spouse is designated on behalf of a child or dependent. An employer, business entity, etc., that pays the proceeds in accordance with an ineffective designation is only liable if written notice was received that the designation was ineffective prior to payment and the payor has not interpleaded the funds into the registry of the court. 16

Naming the Spouse as Beneficiary Surviving Spouse s Options: Tax free rollover into a spousal IRA. This is usually the optimal choice as the Surviving Spouse can name new beneficiaries and can delay taking distributions if not yet age 70 ½. The detriment of a spousal rollover is that the Surviving Spouse cannot take distributions until age 59 ½ without incurring a penalty. Elect the Five year payout. 17

Naming the Spouse As Beneficiary Elect a payout based on the life expectancy of the surviving spouse, but payout must begin on or before the later of: December 31 of the year following the year of participants death. December 31 of the year participant would have attained age 70½ (i.e., the surviving spouse gets to wait until the participant would have reached his or her RBD). Note: If the surviving spouse dies before the first required minimum distribution, then beneficiaries who succeed to interest of the surviving spouse, may take required minimum distributions under the life expectancy payout method as though surviving spouse were the participant. 18

Naming the Spouse As Beneficiary Planning Option: Elect to delay a spousal roll over until Surviving Spouse attains age 59 1/2. Risk: If the Surviving Spouse dies before electing a roll over, then successor beneficiaries who succeed to Surviving Spouse s interest must continue taking Minimum Distributions using the Surviving Spouse s life expectancy, calculated under the Fixed Method. 19

Alternatives That Benefit Surviving Spouse For planning purposes, designations of certain trusts which benefit the surviving spouse may be made as an alternative to an outright beneficiary designation of the spouse. Basic Rules for Designating Trusts as a Beneficiary: The trust must be valid under state law. The trust must be irrevocable or become irrevocable upon death of participant. The trust beneficiaries must be identifiable. A copy of trust document must be provided to the plan administrator or the IRA custodian by Oct. 31 of calendar year following calendar year of participant s death. 20

Alternatives That Benefit Surviving Spouse Designation of a QTIP Trust as Beneficiary: Naming a QTIP Trust as beneficiary will qualify for full marital deduction from estate taxes if the QTIP election is made on the estate tax return and the trust is properly drafted. Naming a QTIP Trust as beneficiary helps protect the ultimate disposition of assets in accordance with participant s desires. Consideration must be given to community property interest of spouse, if applicable. May need to designate 50% to spouse and 50% to QTIP Trust. A partial QTIP election can be made if necessary to maximize use of available estate exemption amount of participant. 21

Naming QTIP Trust as Beneficiary Naming a QTIP Trust as a beneficiary of a qualified plan involves complex estate planning. See IRC 2056. A QTIP is usually designated as the beneficiary of a qualified plan only when outright gift is not feasible. Careful drafting is required to ensure designation of the QTIP Trust qualifies for the marital deduction. Pursuant to Rev. Rul. 2000 2, the spouse must be able to compel distribution of income from the IRA through the QTIP Trust. There is a potential gift issue if spouse fails to take all income from the qualified plan and does not have a special power of appointment over trust assets. 22

Sample QTIP Language For Qualified Plan Benefits Special Provisions Regarding IRA and Qualified Plan Benefits. If the QTIP TRUST shall be the beneficiary of any benefits from a qualified plan as defined in Internal Revenue Code 401(a) or an individual retirement account ( IRA ) as defined in Internal Revenue Code 408(a), then Settlors direct the trustee to treat distributions from any qualified retirement plan or IRA as income of the QTIP TRUST to the extent of the greater of income generated or deemed to be generated by such plan or individual retirement account or the amount determined to be income under the Texas Trust Code. For purposes of determining income, fiduciary accounting principles shall be applied. 23

Sample QTIP Language For Qualified Plan Benefits(Cont d) In determining the amount of income of the QTIP TRUST to be distributed to the surviving Settlor with respect to the qualified plan or IRA benefit, the trustee shall determine such income so that in all events the surviving Settlor shall have a qualifying income interest for life as provided in Internal Revenue Code 2056(b)(7). The trustee shall not charge to income any expense properly chargeable to the principal portion of any distribution. In addition, the trustee shall have the right in its discretion to: (a) Require the qualified plan trustee or IRA custodian to convert non income producing assets or low income producing assets into income producing assets or assets producing adequate income. (b) Withdraw any part or all of the remaining qualified plan benefit or IRA, including, but not limited to assets sufficient to meet the required minimum distribution rules. 24

Naming QTIP Trust as Beneficiary Detriments of designating a QTIP Trust as the plan beneficiary: Minimum distributions are calculated on the Surviving Spouse s lifetime only; Surviving Spouse cannot defer distributions until reaching age 70 ½ as with a spousal rollover; Surviving Spouse cannot name younger individuals as designated beneficiaries (no stretch out). 25

Alternatives That Benefit Surviving Spouse (Cont d) Designation of a Bypass Trust as Beneficiary Naming Bypass Trust as beneficiary helps protect ultimate disposition of assets in accordance with participant s desires. Naming Bypass Trust as beneficiary maximizes use of available estate exemption amount of participant. Detriments: Distributions to a Bypass Trust will be subject to income tax thus reducing the ultimate funding of the trust. 26

Naming Bypass Trust as Contingent Detriments (cont d): Beneficiary Distributions from Bypass Trust are considered distributions of principal and not deductible by Trust. To avoid harsh results, language can be added to Bypass Trust to address deductibility of distributions. The five year pay out rule will apply if the Bypass Trust does not have a beneficiary that can be treated as the Designated Beneficiary. The existence of a power of appointment can create concern as to whether the trust can ever qualify as a Designated Beneficiary 27

Naming Bypass Trust as Contingent Detriments (Cont d): Beneficiary If the surviving spouse is the oldest beneficiary, the pay out is based on the surviving spouse s life expectancy. The surviving spouse cannot defer pay out until reaching age 70½. The distributions will be taxed at trust rates if not distributed to beneficiaries. If distributions are based on surviving spouse s life, the distribution schedule will not change at the death of the surviving spouse. 28

Naming Bypass Trust as Contingent Beneficiary Consider Designation of a Bypass Trust as only the Contingent Beneficiary of the plan due to the uncertainty of the available estate tax exemption estate tax purposes. Sample Designation: Primary Beneficiary: Spouse, if he/she is then surviving; Contingent Beneficiary: If Spouse is then surviving, but shall disclaim any portion of my account, then the disclaimed portion of the account is to be distributed to the Trustee of the Bypass Trust created under the Family Trust dated January 1, 2013, as may be amended from time. 29

Sample Bypass Trust Language For Qualified Plan Benefits Distributions to the Surviving Spouse. If this Trust shall be the beneficiary of any benefits from a qualified plan as defined in Internal Revenue Code 401(a) or an individual retirement account ( IRA ) as defined in Internal Revenue Code 408(a), then the independent trustee shall treat distributions from any qualified retirement plan or IRA as income of such trust to the extent of the greater of income generated or deemed to be generated by such plan or individual retirement account or the amount determined to be income under the Texas Trust Code. For purposes of determining income, fiduciary accounting principles shall be applied. The trustee shall not charge to income any expense properly chargeable to the principal portion of any distribution. 30

Sample Bypass Trust Language For Qualified Plan Benefits (cont d) In addition, the trustee shall have the right in its discretion to: Require the qualified plan trustee or IRA custodian to convert non income producing assets or low income producing assets into income producing assets or assets producing adequate income. Withdraw any part or all of the remaining qualified plan benefit or IRA, including, but not limited to assets sufficient to meet the required minimum distribution rules. To the extent necessary to cause the surviving Spouse to be deemed and maintain the status as the sole designated beneficiary for the required minimum distribution rules, the independent trustee shall distribute to the surviving Spouse an amount of income necessary to meet such rules. 31

Non Spouse Qualified Designated Beneficiaries Plan Participant Dies Before Reaching His or Her RBD: If there is only a single Designated Beneficiary, the required distribution period is based upon the Designated Beneficiary s life expectancy. If there are multiple Designated Beneficiaries, then the General Rule is that the required distribution period is based on the life expectancy of the oldest Designated Beneficiary. 32

Non Spouse Qualified Designated Beneficiaries Plan Participant Dies After Reaching His or Her RBD: If the plan has a single Designated Beneficiary, the required distribution period is the longer of: The remaining life expectancy of the Designated Beneficiary; or The remaining life expectancy of the participant. If the plan has multiple Designated Beneficiaries, the General Rule is that the payout of benefits is based on the remaining life expectancy of oldest Designated Beneficiary if longer than the life expectancy of the participant. 33

Non Spouse Qualified Designated Beneficiaries Creating Separate Payout Periods for each beneficiary: Although difficult, you may allow each Designated Beneficiary to utilize their own life expectancy as the payout period by dividing plan assets into separate shares before death of participant. Provide for separate shares for each intended beneficiary upon death of participant. Example separate share language for outright bequests: If Spouse is not then surviving, in separate shares for the following individuals in the percentages shown: 50% to Daughter 50% to Son. 34

Non Spouse Qualified Designated Beneficiaries Example separate share language where trusts are to be utilized to provide protection for minor beneficiaries or for creditor protection: If Spouse is not then surviving, to the Trustee of each separate trust for issue established under the Smith Family Trust dated January 1, 2013, as may be amended from time; each trust to receive the share allocated to issue per stirpes. A planning option may be to utilize post death disclaimers of eldest Designated Beneficiaries. 35

Sample Conduit Trust Language For Qualified Plan Benefits Special Provisions Regarding IRA and Qualified Plan Benefits. To the extent not otherwise provided herein, if any trust shall be the beneficiary of any benefits from a qualified plan as defined in Internal Revenue Code 401(a) or an individual retirement account ( IRA ) as defined in Internal Revenue Code 408(a), then Settlors direct the trustee to treat distributions from any qualified retirement plan or IRA as income of such trust to the extent of the greater of income generated or deemed to be generated by such plan or individual retirement account or the amount determined to be income under the Texas Trust Code. For purposes of determining income, fiduciary accounting principles shall be applied. The trustee shall not charge to income any expense properly chargeable to the principal portion of any distribution. In addition, the trustee shall have the right in its discretion to: 36

Sample Conduit Trust Language For Qualified Plan Benefits (cont d) (a) Require the qualified plan trustee or IRA custodian to convert nonincome producing assets or low income producing assets into income producing assets or assets producing adequate income. (b) Withdraw any part or all of the remaining qualified plan benefit or IRA, including, but not limited to assets sufficient to meet the required minimum distribution rules. To the extent necessary to cause the current beneficiary of a trust to be deemed and maintain the status as the sole designated beneficiary for the required minimum distribution rules, the independent trustee shall distribute to such current beneficiary an amount of income necessary to meet such rules. 37

Beneficiary Designations For Other Life Insurance and Bank Accounts: Spouse as Beneficiary Non Probate Assets Naming spouse as the beneficiary qualifies for full marital deduction. Ownership: Spouse may have a community property interest and own a ½ interest in policy or account that is held solely in deceased spouse s name. Consideration must be given to ownership of spouse when designating beneficiaries. Divorce: 9.301 of the Family Code provides that a pre divorce designation of an ex spouse as beneficiary under a life insurance policy will not be effective unless required by the divorce decree or a re designation is made or the ex spouse is designated on behalf of a child or dependent. An insurer who pays the proceeds in accordance with an ineffective designation is only liable if written notice was received that the designation was ineffective prior to payment and the insurer has not interpleaded the funds into the registry of the court. 38

Beneficiary Designations For Other Non Probate Assets Spouse as Beneficiary (Cont d): Alternative To Designating Spouse: With proper estate planning in place which includes a trust that provides for creation of a bypass trust, a QTIP trust and/or a surviving spouse s trust, then the umbrella trust can be named as the beneficiary. This will allow the trustee to allocate the proceeds to the proper trust and will allow maximum use of the available estate tax exemption for the insured/account owner. A Bypass Trust can be named as the contingent beneficiary if insurance proceeds are needed to maximize use of estate tax exemption. Example language for beneficiary designation of insurance: Spouse, if he/she is then surviving; If Spouse is then surviving, but shall disclaim any portion of my account, then the disclaimed portion of the account is to be distributed to the Trustee of Trust B (Bypass Trust) under the Smith Family Trust dated January 1, 2013, as may be amended from time. 39

Beneficiary Designations For Other Children as Beneficiaries: Non Probate Assets 1. Naming minor children as beneficiaries may result in the need for a guardianship. 2. Naming an adult beneficiary to receive proceeds on behalf of a minor child, but failing to provide for a custodianship for the minor child, may result in the adult beneficiary having to make a gift to the minor child (or keeping insurance proceeds/account assets for him or herself). 3. Naming a trust as a beneficiary for each child may provide necessary or desired management and creditor protection regardless of age of child. 40