SHOULD YOU NAME YOUR LIVING TRUST AS BENEFICIARY OF YOUR RETIREMENT BENEFITS?

It is likely that retirement accounts (your IRA or 401k) make up a substantial portion of your estate.  Thus, if you have established a Revocable Living Trust as the centerpiece of your estate plan, it is critically important that you make an informed decision regarding how you designate the beneficiary of these retirement accounts.

Many of our clients have brokerage accounts which contain both IRA accounts as well as either joint or individual investment accounts.  Such non-retirement accounts can (and almost always should) be transferred or re-titled to your Living Trust.  But it is important to note that you cannot transfer retirement accounts to your Living Trust while you are alive.  However, you can (and for reasons we will explain, you often should) designate your Living Trust as a beneficiary (either primary or contingent) of such account.

It is extremely important to understand that retirement accounts will always pass in accordance with the beneficiary designation form on file with the plan custodian or administrator.  It is strictly the beneficiary form that controls the disposition of retirement accounts, regardless of what is provided in your will or trust.  Thus, if you want your retirement account assets to pass in accordance with the terms of your trust, you must make sure that the beneficiary designations direct those funds to your trust.

If your Estate Plan includes a Living Trust, it is essential that you make sure that you pay proper attention to your retirement account beneficiary designations.  When it comes to designating beneficiaries, you have two choices: (1) you can either designate beneficiaries directly by name; or (2) you can designate your Living Trust as beneficiary.

Naming Beneficiaries Directly by Name

The simplest and most straight-forward way to pass your retirement benefits at your death is to simply designate the beneficiaries directly by name.  In some situations, this approach will be sufficient or desirable.

These situations might include those where the sole purpose of creating the Living Trust was to avoid probate.  After all, since all retirement accounts give you the ability to name beneficiaries, the Living Trust is not necessary to avoid probate.  Similarly, if your retirement assets are not substantial, and the beneficiaries of your Living Trust are to receive their distributions outright with “no strings attached,” in some circumstances it may be preferable to forego naming the trust. The most common scenario for designating the beneficiary directly is for your spouse.  Planning for a spouse involves several critical issues and is discussed below.

It is important to realize that naming beneficiaries directly only allows you to direct that the benefits will pass to who you want.  If you have gone to the trouble of creating a Living Trust, you have taken steps to provide that the benefits will pass to who you want the way you want.   In order to do that, you will need to designate your Living Trust as beneficiary of the account.

Naming Your Living Trust as Beneficiary

Your Living Trust contains your personal instructions as to how – not just to whom – your assets will be distributed. A well-designed trust will contain provisions for various contingencies, (for instance, directions that if the beneficiary is deceased, whether their share passes to their children, and if those children are minors, to a trust for their education and support).  If you don’t specifically designate the Living Trust as beneficiary, then none of the instructions and directions included in the trust will apply to your retirement assets.

There are some situations where designating a trust is essential:

• Beneficiary is a minor : If you designate a minor as beneficiary, a guardian or custodian will have to be appointed, possibly through court proceedings, and the funds might have to be distributed outright to the beneficiary on their 18^th  If you have a Living Trust, the trust will contain provisions that allow the person you prefer, as trustee, to make distributions for the beneficiary’s health, education and support until the beneficiary has sufficient maturity.

• Beneficiary can’t be trusted: If you simply designate the beneficiary by name, he or she will be able to do anything they want with the money.  If you have established a trust to provide protections for the beneficiary because of addiction issues, irresponsibility or immaturity, designating the trust – rather than the irresponsible beneficiary himself – will ensure that your retirement funds can be managed by the Trustee for the beneficiary’s benefit.

• Beneficiary is disabled: If you want to ensure that benefits that pass to a disabled beneficiary will be available to them, but not disqualify them from public benefits to which they might otherwise be entitled to, then your Living Trust needs to be specified as the beneficiary – not the beneficiary himself.

• Your Living Trust may contain provisions that will protect a beneficiary’s interest in the event of divorce, bankruptcy or lawsuits. If the beneficiary is simply designated by name instead of as a beneficiary of your trust, then those protections will be lost.

• Perhaps the most important feature of your Living Trust may be that it can “keep it in the family.” Your trust can provide a structure that ensures that the wealth you leave to your children, if they don’t spend it all during their lifetime, will ultimately pass down to their children, if they have any, and otherwise to your other descendants or other named beneficiaries in your trust.  Your trust can provide instructions regarding all possible scenarios for what happens if a beneficiary does not survive you.  For example, if your daughter is named as beneficiary of your IRA, but she does not survive you (and assuming you have not updated the beneficiary designation form) the IRA will be distributed in accordance with the financial institution’s policy or the “boilerplate” provisions on the form.  The account may go to her spouse, or to her children, or to her probate estate.  If she has a minor child, that child’s share of the IRA will have to go to a court-appointed guardian, and will be distributed outright (with no strings attached) to the child when he turns 18.  On the other hand, if your IRA passed instead to your Living Trust, the terms of the trust would apply, so that those provisions you included to “keep it in the family” will control. But again, unless the Living Trust is specifically designated on the beneficiary designation form, those directions will not apply.

Planning for Your Spouse

The biggest advantage that retirement accounts have is the tax-deferred wealth accumulation they provide. A primary investment goal common to all of us is to keep our retirement savings within the tax-deferred environment our IRA or 401(k) provides for as long as possible, even after our death.

Under the tax laws, a surviving spouse who is named as beneficiary can do something nobody else can do – that is, a “spousal rollover.”  This results in the spouse becoming the owner of the account and being able to defer withdrawals for as long as possible.  This will usually provide the longest “stretch out” – keeping the money in the tax-deferred environment as long as possible.

Consequently, for many married couples, it may be advisable to designate their spouse as the primary beneficiary of the retirement accounts.

But again, things are not that simple.  If you name your spouse as beneficiary of a retirement account, the account belongs to them when you die.  It is now their account – not yours.  That means they have total control over it, and can designate whoever they later choose to be the beneficiary of any remaining balance.  This is fine if your intended beneficiaries are the same as hers, as where your children are her children.  But what if you have a “blended” family?  Perhaps your plan today provides that when the second spouse dies the assets are divided between your kids and hers.  But are you confident that if you die first, your spouse won’t later decide to change the IRA beneficiary designation form to name only her kids?  If not, then you might want to include provisions in your Living Trust to safeguard against that happening.  If so, then you may want to have the trust designated as beneficiary instead of your spouse.

It should be noted that even if both spouses have the same heirs, some may want to protect against the risk that the surviving spouse may re-marry and (intentionally or unintentionally through divorce) leave the retirement assets to someone else.  Including specially tailored provisions in your Living Trust and designating the trust as beneficiary of some or all of your retirement accounts is sometimes the best solution.

Your Living Trust can include provisions that upon your death, a “Spousal Trust” is created.  This trust may provide that the spouse receives distributions for their health, maintenance and support (whatever the surviving spouse needs), but otherwise, the assets remain in the trust.  Unlike in the situation where the spouse is named directly as beneficiary, the spouse does not become the owner of the retirement account.  Rather, they are the beneficiary.  Accordingly, the surviving spouse has no ability to change the terms of the trust insofar as it provides that the assets that are not needed for the spouse’s support will pass to the deceased spouse’s intended beneficiaries.

A Word About the Tax Considerations of Naming a Trust as Beneficiary of your Retirement Account

There are many misconceptions about the tax implications of naming a trust as beneficiary of a retirement account.  This is understandable since the rules governing distributions at death have been changing and new strategies have been developing to alleviate most of the disadvantages.

While a full discussion of tax issues is beyond the scope of this article, suffice it to say that designating a properly designed trust as beneficiary will not present any negative estate or income tax consequences.

The two most frequently raised objections are: (1) the complexity of the rules relating to minimum required distributions that apply when a trust, rather than an individual, is designated as beneficiary; and (2) the higher income tax rate that applies to trusts.

In 2019, the SECURE Act essentially put an end to the ability of a beneficiary to “stretch” the distribution of an inherited account over the beneficiary’s lifetime.  Before SECURE, it was much harder to navigate the very complex “stretch” rules if the beneficiary was a trust as opposed to an individual.  Under present law, however, it essentially makes no difference whether you name, for example, your daughter directly, or a trust for her benefit, as beneficiary.  And by naming the trust, you can achieve all of the benefits you have included in the trust, which may include protecting the retirement benefits separate from divorce, bankruptcy and lawsuits and ensuring that whatever portion remaining at her death will pass to your grandchildren.  If, on the other hand, you simply name your daughter directly as a beneficiary, those protections are lost.

Another common objection to naming a trust as beneficiary of a retirement account is that, in general, any income that is taxable to a trust will be taxed at higher rates than would be incurred by an individual.  However, by utilizing an innovative technique known as a “Beneficiary Deemed Owner Trust” (“BDOT”), this can be avoided.  Indeed, for clients with large estates (especially those employing Generation-Skipping provisions), the tax advantages can be multiplied.

Essentially, a “BDOT” is a trust that allows the beneficiary to withdraw the trust’s annual income.  Giving the beneficiary that power (whether or not it is actually exercised) causes the income to be taxed at the beneficiary’s tax rate – and not at the (usually) higher rate applicable to the trust.  Consequently, the non-tax benefits of the trust can be achieved without any tax disadvantages.

The Bottom Line

In summary, your Living Trust provides many benefits that can be critically important in achieving your estate planning goals.  If you want these benefits to apply to your retirement account assets, then you must name your Living Trust as beneficiary.  Fortunately, most of the previous impediments to doing so are now gone or can be minimized or avoided.  That being said, taking advantage of the new opportunities available requires careful consideration of your particular situation and your overall estate plan and a thorough review of your trust document to ensure it is specifically designed to qualify as an appropriate beneficiary.

James A. Hyatt, Attorney at Law & MaKayla Hanington, Attorney at Law
Hyatt & Hanington, LLC

Disclaimer: The information provided in this article is for general informational purposes only and does not constitute legal advice. Reading this article does not create an attorney-client relationship between you and the authors or their law firm. You should not act or rely on any information contained herein without first seeking the advice of a qualified attorney licensed in your jurisdiction.