Baby Boomers Beware!
I have found over the years that many of my baby boomer estate planning clients share the same common facts: (1) their IRAs, 401(k)s, or other qualified retirement accounts are typically their largest asset; and (2) they increasingly have blended families – meaning, they are in their second or third marriage and have children from prior relationships. Since most baby boomers’ largest assets are their IRAs, they need to be careful when designating their beneficiaries for these accounts. This becomes especially important when the account owner has a blended family. Failing to properly plan their IRA beneficiary designations can result in the accidental disinheritance of a child, create unnecessary legal fees, and trigger significant income tax consequences for their family. Unfortunately, most IRA account owners are unaware of the complicated rules surrounding beneficiary designations and so the estate plan they thought was in place does not become a reality. This article will address common pitfalls for IRA beneficiary designations for blended families.
Pitfall 1: The Account Owner Names His or Her Spouse as Beneficiary
Most commonly, an IRA account owner will designate his or her spouse as beneficiary. In some situations, this designation works just fine, but other times, and especially for those in blended families, naming the spouse as beneficiary will make their estate plan inconsistent with their overall estate planning goals.
When a surviving spouse inherits an IRA, they can choose how the IRA is paid out, including, but not limited to: (1) rolling it over into their own IRA; or (2) cashing it in, paying taxes, and spending the proceeds at their discretion. To learn more about the different options surviving spouses have, please click here. Surviving spouses also have the opportunity to designate their own beneficiary on their inherited IRA. Oftentimes, a surviving spouse will designate a beneficiary who is inconsistent with those who the account owner originally intended, such as the surviving spouse’s new spouse or to the surviving spouse’s own children. The surviving spouse has no obligation to leave the IRA asset to any of the account owner’s children from a prior relationship. Most baby boomers with blended families want to provide for their own children upon the death of their surviving spouse, but are unaware that simply naming their spouse as beneficiary of the IRA could compromise their estate planning goals if their surviving spouse leaves the IRA to someone other than their own children. An IRA account owner can avoid this problem by setting up a trust and naming the trust as the IRA beneficiary instead of the surviving spouse. This solution is discussed in further detail below. IRA account owners are encouraged to consult with their attorney, CPA, and financial advisor to determine if naming their spouse as their IRA beneficiary is an appropriate option to meet their estate planning goals.
Pitfall 2: The Account Owner Names His or Her Trust as Beneficiary
Naming a trust as the IRA beneficiary instead of their spouse is a typical option for clients in blended families who want to ensure that their IRA will pass down their blood line. A typical trust for a baby boomer client provides that upon the first spouse’s death, the trust provides for the surviving spouse, and upon the survivor’s death, the remaining assets are distributed to the designated children and stepchildren in equal shares. As long as the IRA account owner’s children are beneficiaries under the trust, naming the trust as the IRA beneficiary will ensure that his or her children from a prior relationship will not be left out. This prevents the spouse from inheriting the IRA outright and leaving it to someone other than the account owner’s children. However, naming a trust as the beneficiary of an IRA comes with its own faults, as discussed below.
The biggest problem with naming a trust as IRA beneficiary is that if the trust is not drafted properly to optimize tax deferral for IRAs, there could be significant income tax consequences for the account owner’s family. There are certain requirements a trust must have to qualify as a designated beneficiary of an IRA to receive favorable tax treatment. If these specific requirements are not met, the trust will not receive a favorable “stretch” payout method option that individual beneficiaries otherwise enjoy. The stretch IRA payout method “stretches out” the distributions from the IRA over the life expectancy of the oldest identifiable beneficiary of the trust, which in turn stretches out the annual income tax liability for each beneficiary. When a trust is not drafted properly, the trust beneficiaries will be disqualified from receiving this favorable tax treatment. Instead, the beneficiaries are required to take either a lump sum distribution of the IRA or take distributions over a 5 year period. For more discussion on payout options for trusts and other non-spouse beneficiaries, please click here.
Another issue that arises when an account owner names a trust as IRA beneficiary is that the account owner does not properly fill out the beneficiary designation form with the IRA custodian. If proper language is not used on the beneficiary form, the account owner may encounter difficulty with the custodian accepting the designation. Furthermore, depending on the language of the trust, if the trust is split into sub-trusts for the children and the sub-trusts are not specifically identified as the beneficiaries of the IRA, the children may not be able to use their own life expectancy for the tax-preferred stretch payout method.
It may seem simple in theory, but designating the right IRA beneficiary can be complicated. Baby boomers in blended families need to be aware of the consequences of naming the wrong beneficiary of their IRAs. IRA account owners are encouraged to meet with their attorney, CPA, and financial advisor before naming their spouse or trust as their IRA beneficiary so that their IRA beneficiary designations will meet their overall estate planning goals.
Bill Hesch is a CPA, PFS (Personal Financial Specialist), and attorney licensed in Ohio and Kentucky who helps clients with their financial and estate planning. He also practices elder law, corporate law, Medicaid planning, tax law, and probate in the Greater Cincinnati and Northern Kentucky areas. His practice area includes Hamilton County, Butler County, Warren County, and Clermont County in Ohio, and Campbell County, Kenton County, and Boone County in Kentucky.
(Legal Disclaimer: Bill Hesch submits this blog to provide general information about the firm and its services. Information in this blog is not intended as legal advice, and any person receiving information on this page should not act on it without consulting professional legal counsel. While at times Bill Hesch may render an opinion, Bill Hesch does not offer legal advice through this blog. Bill Hesch does not enter into an attorney-client relationship with any online reader via online contact.)