VI.    Designating Beneficiaries of IRAs and Pension Benefits Payable Upon Death

            It is not uncommon for individuals to accumulate significant investments in pension and profit sharing plans, individual retirement accounts, annuities, and similar assets.  Although these investments are generally set aside for the purpose of funding expenses of the individual during retirement, there is always the possibility that a premature death will leave significant assets remaining to be distributed to a designated beneficiary upon the death of the account owner.

            Individuals who are married generally name their spouse as the primary beneficiary in order that the surviving spouse may roll over the pension fund or individual retirement account to another IRA and defer the income tax until the money is taken out when needed for living expenses or required to be distributed under the minimum distribution rules.  More complicated issues arise in naming a contingent beneficiary or if one is an unmarried individual and there is no spouse eligible for the favorable roll over option.  In deciding upon a designated beneficiary, people generally seek one or both of two common objectives.  The first is assuring that the proper beneficiary receives the funds under various alternative events.  The second is the deferral of income taxes to the extent practical. 

             A.        Appropriate Beneficiary.

                        To satisfy the first of these objectives, there are a variety of reasons why designation of a trust as a beneficiary is often desirable.  Some of those reasons include the following:

            1.   If an individual beneficiary is immature or otherwise unable to manage the funds to be distributed, designating a trust places the funds under the control of a trustee who may invest them properly and distribute them according to terms and conditions described in the trust to assure the maximum benefit for the individual beneficiaries of the trust.

            2.  The trust may contain unlimited and detailed contingent beneficiary provisions providing for alternate distribution in the event the primary individual beneficiary dies prematurely.

            3.   A special needs trust is sometimes required for beneficiaries who are receiving government benefits to assure that those benefits are not terminated as a result of the individual being a direct owner of assets that would make them ineligible for government assistance.

            4.   Payment of funds to a trust is sometimes necessary to assure full use of the available estate tax credits upon the death of each spouse.

             B.        Deferral of Income Tax.

                        Since these distributions are all subject to income tax with the exception of funds in a Roth IRA, deferral of that income tax is often desirable depending upon the needs of the alternate beneficiaries and their current income tax bracket taking into account other income each is receiving.  For example, a $100,000 distribution could be depleted by as much as $40,000 in income taxes (depending upon the federal and state income tax bracket of the taxpayer) to reduce the after tax amount received to only $60,000.  If the $100,000 amount were paid over the life expectancy of the beneficiary, the $100,000 would earn more over the years it remains in the account and therefore result in distributions considerably more than the $60,000 remaining if the money had been paid all in the initial year of death.  However, the beneficiary must select payment over his or her life expectancy if this deferral of income tax is to be attained.  Beneficiaries are not always inclined to make that decision, and holding the funds in a trust where the trustee could make such decision is often desirable.  Therefore, if an individual desires to control distribution through a trust and maximize the income tax deferral,  a number of hurdles must be overcome in order to achieve these objectives.

             C.        Retirement Plan Limitations.

                         Notwithstanding how well drafted a trust may be that is designated as beneficiary of qualified retirement plan benefits, the terms of the plan control the type of pay out allowed upon the death of the employee or owner of the plan benefits.  Unfortunately, most pension plans require a trust designated as a beneficiary to take the entire amount in a lump sum upon death of the plan participant or owner of the benefits.  This causes immediate taxation of the entire amount at the trust’s rate which is generally higher than most individuals.

                         Therefore, most employees cannot take advantage of the maximum tax deferral if their desire is to assure the proper distribution through a trust.  However, naming individuals as the direct beneficiaries creates a risk that those individual beneficiaries will not use the money for their best advantage.  Although naming individuals as beneficiaries may give them the option to defer payment over a longer period of time, there can be no guarantee that a beneficiary will not take the lump sum, pay the substantial tax that is due, and immediately spend the balance in a less than optimal manner.

                         Because of these limitations, many employees roll over their pension benefits to an individual retirement account as soon as allowable.  Provided that the IRA account agreement allows (as is generally the case) the owner to name a trust as a beneficiary and have it not paid in full upon death, the roll over to an IRA enables the account owner to allow deferral of distribution and payment of taxes.  Therefore, each qualified retirement plan should be reviewed to determine whether payment to a trust will cause immediate taxation at the income tax rates of the trust which are generally higher than those of individual beneficiaries.  The trust will pay at the highest marginal rate on income above $9,950.  If permitted, plan benefits should be rolled over to an IRA to increase distribution options.

                         Selection of an IRA plan custodian also requires care as not all custodians allow trusts to achieve the maximum deferral.  Careful review of the IRA agreement is necessary to be certain that desired options may be obtained.

             D.        Requirements for Conduit Trust.

                         In understanding the principles applicable to income taxation of IRA and pension benefits payable to a trust as designated beneficiary, it is important to first recognize that the IRS has issued regulations indicating how a trust will qualify as a look through trust in order that the benefits would be taxable to the beneficiaries at their rates over the longer period of time that the benefits may actually be paid from the account through the trust to the individual beneficiary.  Generally, there are four requirements the trust must satisfy:

             1.  The trust must be valid under state law.

             2.  The trust must be irrevocable or become irrevocable when the IRA owner dies.

             3.  The trust beneficiaries must be identifiable from the trust agreement.

             4.  The IRA custodian must be provided with proper documentation within a specified period of time.

                         The first two of these requirements are generally easy to meet.  The fourth requirement may be satisfied by providing the documents no later than September 30 of the year following the year in which the account owner dies.  Although the third requirement seems to be one that would be fairly easily satisfied, it actually raises a number of complicated issues.

                         First, a recent IRS ruling indicates that if an estate, charity, or other non-individual is included as one of the trust beneficiaries, the trust will not qualify for look through treatment.  Even payment of debts, administration expenses, or death taxes can disqualify a trust that is desired to serve as a conduit for pension or IRA benefits payable through the trust.  Therefore, it is important to provide in the trust agreement that payments of IRA benefits may not be used for those distributions and expenses.  If the trust does not include those provisions, it is important that such distributions and expenses be paid prior  to September 30 of the year following the year of death in order that the trust will then qualify as a proper beneficiary for treatment as a conduit.

                         Second, it is important that the IRA remain in the name of the original owner.  The account should remain in the owner’s name even though the proceeds are being paid to the trustee for distribution to the beneficiaries.

                         Third, arrangements must be made to take the first minimum required distribution  by the end of the calendar year following the year of the owner’s death in order to avoid a 50% penalty.  In the best case, the trustee will select a minimum required distribution based on the single life expectancy of the trust beneficiary.

                         Fourth, arrangements should be made to obtain separate account treatment if possible.  If several individuals are named to receive retirement benefits, the life expectancy of the oldest member of the group is used for distributions to each member of the group.  This could be a significant disadvantage for the beneficiaries who  are younger than the oldest beneficiary because it causes the distribution to be made over a shorter period of time and in greater amounts each year.  If the individual retirement account and the trust provide for division into separate accounts and separate trusts for each beneficiary, it is possible to provide for the distribution to be paid over the individual life expectancy of each beneficiary of the trust.  It is therefore important to review both the trust and the individual retirement account for verification that separate account treatment is available.

                         Fifth, additional consideration must be given to identification of the beneficiary since contingent beneficiaries are sometimes ignored and other times taken into account for determination of the life expectancy to be used in calculating the minimum required distribution.  For example, if a trust provides that a young beneficiary would receive assets for education, health, and support with the remaining principal being distributed at ages 25, 30, and 35, one must take into account the beneficiaries who would receive the assets if the primary beneficiary died before age 35 unless the trust provides that minimum required distributions will not be accumulated but distributed to the beneficiary each year.  A requirement that the minimum required distribution amount be distributed to the beneficiary each year would enable the trust to be considered a conduit.  However, some believe such a provision might be undesirable since it could cause more funds to be distributed to a young or immature beneficiary each year than is advisable for the best interest of the individual beneficiary.  Therefore, whether such a provision would be included in a trust is a matter of individual determination in each case.

                         Although some practitioners believe some of the IRS rulings may be inconsistent with the regulations and therefore not enforceable, the cost of litigation to resolve such issues is considerable.  Therefore, one must carefully determine how to designate beneficiaries in order to avoid unnecessary expense in resolving such issues with the IRS through litigation.  We recommend that anyone who has not recently reviewed their retirement and IRA beneficiary designations do so immediately in order to be certain that they are consistent with their current intentions.