Individual retirement accounts have long been treated as the proverbial red-headed stepchild of estate planning. Until recently, they were often overlooked, dismissed or disregarded when estate planning was undertaken. But with upwards of $14 trillion in tax-deferred retirement accounts, $4 trillion of which is estimated to be held in IRAs, they've become a force to be reckoned with. According to the Employee Benefits Research Institute in Washington, D.C., IRAs now hold approximately 25 percent of all retirement assets in the United States.1 Obviously it's no longer an option to overlook, dismiss or disregard this aspect of estate planning.
Even now, as estate-planning practitioners have begun to give IRAs their due respect, IRA owners sometimes use a “do it yourself” (DIY) approach and are reluctant to pay attorneys' fees for filling out a beneficiary designation form that they believe they could very well fill out on their own.
But the same DIY IRA owners will often expend considerable time and resources for estate-planning services when the final product has little or no effect on the ultimate disposition of the IRA assets. Often, the value of the IRA alone far exceeds the value of the “planned for” estate. Unfortunately, in most states, the four corners of the beneficiary designation form will determine the ultimate recipient of the IRA proceeds. Based on whether the lucky recipient is considered a “designated” beneficiary, the Internal Revenue Service will determine how much tax deferral is available.2 The end result is that whatever the IRA owner may have saved by avoiding the cost of legal advice regarding the IRA during his lifetime may very well be spent, and in many cases exceeded, by post-mortem maneuvering required to correct mistakes and oversights and the premature loss of tax deferral suffered by the IRA beneficiaries.
To put this in perspective, it's important to first understand the rules of engagement. The IRS released final IRA regulations on April 16, 2002 (IRA rules).3 The IRA rules have created new post-mortem planning opportunities with regard to IRAs. The basic post-mortem distribution rules provide for required minimum distributions (RMDs) to beneficiaries upon the death of the IRA owner. IRA monies aren't subject to income tax until distributed, either to the IRA owner, or after the death of the IRA owner, to beneficiaries. Distributions are taxed at the recipient's income tax rate.
The amount of tax deferral available depends on the age of the IRA owner at death, whether a beneficiary is named and whether that beneficiary is considered a “designated” beneficiary. To be considered a “designated” beneficiary, the first hurdle is actually being named on the beneficiary form. Then, the named beneficiary must be either an individual or a qualified trust. Two of the requirements needed for a trust to be “qualified” are that the trust must be valid under state law and become irrevocable by its own terms upon the IRA owner's death. Although estates and charities can be named on the beneficiary forms, they're not considered “designated” beneficiaries in this context.
If there's no designated beneficiary and the IRA owner hadn't reached his required beginning date (RBD) for distributions prior to his death, which is April 1 of the year after the year in which the IRA owner turned 70½, then the deferral period available will be five years.4 If the IRA owner hadn't reached his RBD but had named a designated beneficiary, the maximum deferral period available will be the life expectancy of the oldest beneficiary of each share that qualifies for separate share treatment. If the IRA owner was past his RBD, then the same rule applies if there's a designated beneficiary. If not, then the maximum tax deferral available will be the remaining non-recalculated life expectancy of the decedent IRA owner.5 So what could go wrong?
No Beneficiary Named
Believe it or not, the most common error that occurs with IRA planning is that no beneficiary is named on the IRA at all. This could be due to poor estate planning, the DIY syndrome, a simple oversight or in rare instances, a misplaced beneficiary form. Regardless of the cause, the result is the same. In most cases, the ultimate recipient of the IRA will have a substantially shorter period of time to withdraw the IRA funds than if a beneficiary had been designated. In addition, most IRA providers have default provisions within their IRA documents that name either the estate or the surviving spouse if there's no named beneficiary.
Leaving the IRA to the estate has certain perils. Depending on state law, the IRA may become subject to creditors' claims. It will most definitely be distributed to heirs that are determined pursuant to state law, defeating the IRA owner's intent. Additionally, an unwitting personal representative may cause the entire IRA to be distributed into an estate account, causing immediate taxation and possibly subjecting the personal representative to a surcharge for mismanagement of the IRA assets.
Although a surviving spouse default may seem less perilous, it can be equally devastating if there was a pre- or post-nuptial agreement in place. Being a default beneficiary doesn't guarantee that such an agreement can be overcome or defeated, but in many instances it's enough to sustain litigation until the court orders mediation. Most IRA owners would certainly wish to avoid either result if aware of the potential consequences.
No Contingent Beneficiary Named
Another common problem is that a primary beneficiary is named, but the beneficiary has either predeceased the IRA owner or dies before the IRA is rolled over or retitled. The IRA will be deemed to have no designated beneficiary if an otherwise designated beneficiary predeceases the IRA owner and there's no contingent beneficiary named. When this happens, the default provisions in the IRA agreement will determine the IRA recipient. When a designated beneficiary survives the IRA owner but dies prior to taking possession of the IRA and there's no contingent beneficiary named, then planners are really faced with the lesser of two evils. If the IRA owner and the deceased beneficiary shared the same beneficiaries, the IRA may be paid out either based upon the remaining non-recalculated life expectancy of the IRA owner or the remaining non-recalculated life expectancy of the beneficiary. It's a matter of determining the most beneficial life expectancy to use and then deciding if a disclaimer is necessary. If the deceased beneficiary has a different dispositive plan, the IRA will be payable through the estate of the deceased beneficiary.
Wrong Beneficiary Designated
One might wonder how the wrong beneficiary could be designated on an account. As with other estate planning, this can happen if there has been a falling out between the IRA owner and the named beneficiary.6 Many times, clients update traditional estate-planning documents such as last wills and testaments or revocable trusts to reflect a change in family circumstances or relationships, but they overlook beneficiary designations.
Even if planning is done, a problem can occur if the planning is inadequate to account for all contingencies. This is of particular concern in the “pre-portability” world or when portability isn't properly used. Consider a situation in which one spouse is “monied” with sufficient assets to fund a couple's federal estate tax exemption amount, but the other spouse doesn't have enough assets to fund the exemption amount. The “non-monied” spouse dies first, and the only substantial asset in that spouse's name is an IRA. Traditional wisdom suggests it's most prudent in a long-term marriage to name the spouse as the primary beneficiary because spouses have so many more options than non-spouse beneficiaries when an IRA is inherited, and in most cases, the spouses share the same dispositive intent.7 Assume that the IRA owner spouse named the “monied” spouse as the primary beneficiary. Although naming the spouse as the primary beneficiary is the best choice from a tax deferral standpoint, if the goal was for the IRA to be includible in the deceased IRA owner's estate for estate-tax purposes, naming the surviving spouse as the primary beneficiary won't accomplish this goal. If no contingent beneficiaries are named, it might be necessary for the beneficiary spouse to disclaim the IRA for inclusion in the IRA owner's taxable estate. If the spouse disclaims, it's most likely that the IRA would be payable to the IRA owner's estate. The IRA will be treated as having no designated beneficiary, and the deferral will be limited to either five years or the remaining non-recalculated single life expectancy of the deceased IRA owner.
Naming an Ex-spouse
Florida, like many states, requires equitable distribution in the event of divorce.8 Clients often overlook changing beneficiary designations after divorce. An online search of case law on IRAs reveals a proliferation of cases involving this very issue. The seminal case in Florida is Cooper v. Muccitelli.9 In an all too familiar fact pattern, the former husband died without changing his beneficiary designation to remove his former spouse. The Florida Supreme Court concluded that the husband had the ability to name any beneficiary of his choosing and that he received clear instructions regarding making a change of beneficiary. He took no action after the divorce to effectuate a change and, therefore, the former spouse remained the beneficiary. This situation may be avoided with specific language in the separation agreement10 regarding division of the IRA or by simply executing a new IRA beneficiary designation.11
Currently, Estates and Trusts Sections 737.106 and 732.507 of the 2010 Florida Statutes provide that when someone fails to change their revocable trust or will after divorce,12 the former spouse will be treated as having predeceased the decedent. The sections don't, however, govern any account with a disposition that's determined by a beneficiary designation, such as an IRA.13 The Real Property, Probate and Trust Law Section of the Florida Bar has proposed a statute that would provide a similar presumption for IRAs and other pay-on-death accounts.
Named Beneficiary Isn't a Legal Entity
Believe it or not, there are situations in which IRA owners have named a spouse's IRA account as a beneficiary instead of the spouse individually. An account isn't considered a person or an entity like a trust or estate. Not only is an account not a designated beneficiary, but also, it's not a beneficiary at all. According to “Retirement Topics-Beneficiary” in www.irs.gov , “[a] beneficiary can be any person or entity the owner chooses to receive the benefits of a retirement account or an IRA after he or she dies.” An “account” is not a “legal person, persons or legal entity” required to be considered a valid IRA beneficiary pursuant to the Internal Revenue Code, most IRA agreements and beneficiary designation forms. The common law definition of a legal entity is an association, corporation, partnership, proprietorship, trust or individual that has legal standing in the eyes of law. A legal entity has legal capacity to enter into agreements or contracts, assume obligations, incur and pay debts, sue and be sued in its own right and be held responsible for its actions. It's unfortunate when an account is named because in most cases, it will be payable to the deceased IRA owner's estate unless a contingent beneficiary is also designated.
Annuity With Different Beneficiaries
A growing area of concern in the world of IRA administration regards IRA annuities. It's possible for the IRA owner to transfer an IRA annuity into another IRA to consolidate accounts for ease of recordkeeping. If handled correctly, the IRA owner is still the annuitant, but the IRA is the owner and beneficiary of the annuity. The annuity becomes an asset of the IRA. If the ownership and beneficiary designation can't be changed to reflect the IRA, the financial advisor or IRA custodian should advise the IRA owner to handle the IRA annuity as a totally separate account. But we don't live in an ideal world. It's possible for the annuity to have beneficiaries designated that are different from the IRA account holding the annuity. If annuities within IRAs aren't handled properly, this can result in a situation in which there are conflicting beneficiary forms, which can end in litigation to determine the proper beneficiaries. This leads to unnecessary court costs, legal fees and a possible loss of tax deferral.
As previously stated, the final IRA rules require that a designated beneficiary be either an individual or certain trusts. For a trust to qualify as a designated beneficiary, it must be valid under state law and become irrevocable by its own terms upon the IRA owner's death. Additionally, the trustee of the trust or the personal representative of the IRA owner's estate must provide the IRA trustee or custodian with a list of the beneficiaries of the trust or the actual trust document no later than Oct. 31 of the year after the year containing the date of the IRA owner's death, and the beneficiaries must be easily identifiable through the trust document.14 If a trust meets IRS requirements, it should be eligible for deferral as either a conduit trust or an accumulation trust.
Trust named doesn't qualify for designated beneficiary treatment
It's hard to imagine that a practitioner could draft a trust that wouldn't be valid under state law; however, it's entirely possible to name a trust that isn't totally irrevocable upon the death of the IRA owner. In recent years, there has been a growing trend to create joint revocable trusts for clients with more modest estates. The problem with joint revocable trusts is that only a portion of the trust becomes irrevocable upon the death of the first spouse. Depending on which spouse dies and how the trust is named on the beneficiary form, it's possible to undermine the beneficiary designation altogether by naming a portion of the trust that isn't irrevocable upon the death of the IRA owner spouse.
It's also possible to name a trust that won't qualify because of the identity of the trust beneficiaries. Consider the advent of the pet trust, or as some may prefer, the domestic animal companion trust. A trap for the unwary lies in leaving an IRA to a residuary trust if there's a possibility that, due to some untimely deaths, the residuary trust is payable first to a pet trust before reaching the ultimate residuary beneficiaries. Although we're fond of our domestic animal companions, at this time, I'm unaware of any plans to consider pets as designated beneficiaries in the near future. Another area of concern regards “takers of last resort” if all named beneficiaries have predeceased the decedent. Without careful planning, the trust may not qualify as a designated beneficiary, or even worse, the proceeds could possibly escheat to the state of the IRA owner's domicile.
Estate named instead of testamentary trust
Another common problem with uncommonly bad results occurs when an estate is named on the beneficiary form instead of the testamentary trust that was the intended recipient. The testamentary trust loses the ability to be considered a “designated” beneficiary and much tax deferral opportunity is lost. Even worse, many financial institutions don't seem to understand the right way to retitle IRAs that are payable to testamentary trusts. Even without a designated beneficiary, many times the years of deferral available are in the double digits, yet there are institutions that will immediately distribute IRA funds into a testamentary trust, causing unnecessary acceleration of income taxes. This is another trap for the unwary because when fiduciaries distribute IRA assets without regard for the tax consequences and/or creditor protection issues, they're subjecting themselves to a possible surcharge and even breach of fiduciary duty charges. It's important for all fiduciaries, when dealing with an IRA, to be familiar with the distribution options available.
Revocable trust named instead of intended sub-trust
A revocable trust that becomes irrevocable upon the death of the grantor will, in most cases, qualify as a designated beneficiary. However, if the intended recipient of the IRA is a sub-trust, it's not enough to name the revocable trust. Although the trustee may be trying to get the IRA assets to be payable to the sub-trust, if the surviving spouse is a beneficiary of the revocable trust, in most cases that spouse will be considered the oldest beneficiary of the trust and the measuring life for deferral purposes, thus defeating the intent of creating the sub-trusts in the first place.15 Sometimes a trade-off is required if the IRA is needed to fund a credit shelter trust. By naming the credit shelter trust with provisions for spousal distributions, the IRA will be counted toward the deceased IRA owner's taxable estate, but the spouse will be treated as the oldest beneficiary of the trust and will be denied rollover treatment, thus depriving the children or grandchildren of the ability to use their individual life expectancies.
Careful Review Required
It's incumbent upon all practitioners and fiduciaries dealing with IRAs to be aware of these potential pitfalls and to stay as well informed as possible to help clients avoid costly mistakes and unexpected outcomes. It's also imperative for IRA owners and their professionals to periodically review the IRA agreements and beneficiary designation forms to ensure consistency with existing estate planning and to avoid unnecessary post-mortem complications. In light of the post-mortem opportunities afforded by the IRA rules and the uncertain future of estate taxes, layering the beneficiary designation for contingencies is a prudent approach.
- See www.EBRI.org , “Fast Facts,” #203, June 30, 2011. A substantial portion of these assets originated in other tax-qualified retirement plans, such as defined benefit (pension) and 401(k) plans and were moved to individual retirement accounts through rollovers. Thus, IRAs in many cases have become a repository for assets built up in the employment-based retirement system. “Fast Facts” is issued by the nonpartisan Employee Benefit Research Institute (EBRI) to highlight benefits information that may be of current interest. Established in 1978, EBRI is an independent non-profit organization committed exclusively to data dissemination, policy research and education on economic security and employee benefits. EBRI doesn't take policy positions and doesn't lobby.
- 31 Am. Jur.2d Executors and Administrators Section 502 (1989).
- The new proposed and final regulations are included in Treasury Regulations Section 1.401(a)(9)-0 through Section 1.401(a)(9)-8; Section 1.403(b)-2; Section 1.408-8; and Section 54.4974-2.
- Internal Revenue Code Section 401(a)(9)(B)(ii).
- IRC Section 401(a)(9)(B)(i).
- See Powers v. Hayes, 776 A.2d 374 (Vt. 2001). In Powers, an IRA owner was scheduled for surgery and prior to surgery, he went to his long-time estate-planning attorney and indicated that he wanted to leave all of his assets to his daughter. The attorney prepared a codicil and trust amendment but failed to change or even suggest a change to the IRA beneficiary designation, even though she knew of its existence. The IRA owner died shortly after surgery. His daughter, who was also the administrator of her father's estate, brought suit against the attorney for malpractice, because the IRA (which constituted the bulk of the decedent's assets) was left to the IRA owner's former girlfriend. The lower court granted summary judgment in favor of the attorney and dismissed the malpractice claim, based on the daughter's failure to prove that the attorney's negligence was the proximate cause of her harm. The Supreme Court of Vermont disagreed, stating that there was a genuine issue of material fact with respect to causation and enough circumstantial evidence that the father had intended to leave all of his assets to his daughter. Based on the father's attempt to act on his intent, the court reversed summary judgment.
- IRC Section 401(a)(9)(B)(iv).
- Florida Statute (F.S.) Section 61.075.
- Cooper v. Muccitelli, 661 So.2d 52 (Fla. 1995).
- See also Vaughan v. Vaughan, 741 So.2d 1221 (Fla. 1999); In re Estate of Dellinger, 760 So.2d 1016 (Fla. 2000); Luszcz v. Lavoie, 787 So.2d 245 (Fla. 2001); Smith v. Smith, 919 So.2d 525 (Fla. App. 2005).
- See also Crawford v. Barker, 2011 WL 2224808 (Sup. Ct. Fla. June 9, 2011).
- F.S. Section 737.106 and F.S. Section 732.507.
- See also Schultz v. Schultz, 591 N.W.2d 212 (Iowa 1999); Pinkard v. Confederation Life Insurance Company, 647 N.W.2d 85 (Neb. 2002).
- Treas. Regs. Section 1.401(a)(9)-0 through Section 1.401(a)(9)-8; Sections 1.403(b)-2, 1.408-8 and 54.4974-2.
- For a discussion of these issues, see Private Letter Rulings 200317041 (Dec. 19, 2002), 200317043 (Dec. 19, 2002), 200317044 (Dec. 19, 2002) and 200234074 (May 28, 2002).
Kristen M. Lynch is a shareholder of Ruden McClosky, P.A. in Fort Lauderdale, Fla.