This seems like a simple question, right? My retirement goes to the person I listed as my beneficiary (spouse, kids, etc.). Most of the time this is true, yet we also get a fair share of people having to file a probate for an IRA or having to request the court to allow someone to set up a special needs trust because a beneficiary on a retirement account was receiving Medi-Cal or Supplemental Security Income (SSI). This will address what happens to your retirement accounts when you die and all the possibilities that come with it.
Who decides where your retirement account goes?
It depends, the ubiquitous lawyer answer. In theory, you decide where your retirement goes and can name whomever you want as a designated beneficiary. However, the Tax Code and pension law (ERISA) require that your spouse be the beneficiary on your 401k or pension and IRS Publication 555 Community Property requires that IRAs in community property states (ahem…California) are required to have a spouse either named as the primary beneficiary, or the spouse has to consent if you want to name someone other than your spouse as the beneficiary.
In addition, the custodian of your 401k or IRA is generally not responsible for maintaining your beneficiary designations if your account changes custodians. So, if you notice that your account has changed custodians, or you roll anything over from account to account, make sure your beneficiary designations are current, even completing them again each time the account changes. If a new custodian loses the beneficiary designation, or there is a computer glitch somewhere and the designation gets lost, your account no longer has beneficiaries and might be subject to a probate, which will lead to unnecessary costs and fees. Periodically check your designations and make sure they are up to date. You replace the batteries in your smoke detector twice a year even if they are not beeping right?
Also, if you get divorced, are widowed, get married, or if one of your beneficiaries dies you will want to update your beneficiary designation. However, if you are getting divorced don’t update them too quickly as divorce petitions usually have restraining orders attached that prevent you from changing beneficiary designations until the property has been divided. This is because absent any other agreement, your retirement contributions and earnings during marriage are considered community property in California and subject to division upon divorce.
What happens if there is no beneficiary named on my retirement account or I write “My estate” as my beneficiary?
In California, any assets that do not have a beneficiary named or are not titled in a trust are subject to probate. Probate is a court oversight process that makes sure that all your assets are accounted for and distributed according to your will or California law. If the total amount of your assets subject to probate are over $166,250 then a probate needs to be filed. If the total is less than $166,250 then your heirs can file what is called a Small Estate Affidavit to avoid court and distribute the asset. Most of the time the IRA or 401k custodian will have their own paperwork for a small estate affidavit, and you sign the paperwork under penalty of perjury that no probate is required and list the heirs to the estate. The custodian will then correspond with each heir about what they want to do with their share.
If the amount of the retirement account exceeds the $166,250 then someone will need to petition the court to open a probate and go through the process of gathering all of the decedent’s assets and accounting for everything over which the court will have oversight. It is an arduous process that no one wants to do for an account that could have had a beneficiary named.
What happens when a beneficiary inherits my retirement account?
When a beneficiary inherits part or all of your retirement account they will typically work with the custodian of the account to set up an inherited IRA and they will put their own beneficiaries on their new account. Pursuant to the SECURE Act, which went into effect January 1, 2020, your beneficiary has ten years to withdraw all of the inherited IRA. This means that they can withdraw a portion each year or all at once by the tenth year, or any combination thereof. This could be a tax issue for the beneficiary, particularly if they are in their prime income earning years and anyone who is a beneficiary of a retirement account should seek advice from their tax professional before making any withdrawals.
There are some exceptions to this rule of having to withdraw all the funds within 10 years. The beneficiaries who meet the requirements of the exceptions can still withdraw the inherited IRAs over their life expectancy, which is what the law was prior to January 1, 2020. These exceptions include spouses and beneficiaries who are not more than ten years younger than the account owner. There are a couple of more exceptions to be discussed below.
These exceptions are tied to the individual inheriting and not to the account itself. For example, Harold dies and leaves his wife, Wendy, a $1 million IRA, and Wendy takes required minimum distributions until she dies, leaving an IRA worth $750,000 to her daughter, Dana. Dana will inherit that $750,000 IRA and will have to withdraw all of it within ten years. Before January 1, 2020, Dana would have been able to stretch out that IRA just like her mom, Wendy.
What happens if a minor inherits my retirement account?
A partial exception to the 10-year withdrawal rule is if a minor is the named as a beneficiary on your retirement account. Minor children are exempt from the ten-year rule until they turn eighteen. This means that the ten-year rule goes into effect when they turn eighteen, and they must withdraw all of the funds by their 28th birthday. This means that you could have an eighteen-year-old withdrawing the entire retirement account all at once, resulting in a large tax bill that they will need to set money aside for.
Giving an eighteen-year-old a chunk of money with a significant tax event may not be your plan when it comes to your estate. One way around this is for your retirement account to name a trust as its beneficiary, which allows for the trust and its trustee to control the distribution of funds to your child or children.
What happens if a trust is the beneficiary of my retirement account?
If you name your trust as a beneficiary or contingent beneficiary of your retirement accounts, and the beneficiary of your trust is one or more individuals, then the distribution rules depend on the classification of the individual(s). For example, if the beneficiary is less than 10 years younger than you, then the trust, for the benefit of the individual, can take distributions as though it was the individual, meaning they get the stretch. The advantage of naming a trust as the beneficiary of yur retirement account is that with a trust you can designate a trustee to control when and how the beneficiaries receive the funds.
What happens if a special needs person inherits my retirement account?
If the beneficiary of your retirement account is a disabled child or chronically ill individuals (as defined by the Social Security Administration), then they are able to stretch the retirement account over their lifetime and are not bound by the ten-year rule. This would also apply if they are the beneficiary of a trust that is named as the retirement plan’s designated beneficiary. If your beneficiary is eligible for any public benefits under Medi-Cal (Medicaid) or Supplemental Security Income through the Social Security Administration or any other need-based services, then it would be prudent to speak with an estate planning attorney so that leaving any inheritance, even if it is a retirement account that they can stretch, does not interfere with or disqualify them from public benefits and services. A special needs trust can be set up to receive their inheritance and a trustee can manage the funds such that none of their benefits are affected and they can still benefit from the inheritance.
Retirement accounts seem like a simple tool for leaving a legacy, but they can often be complicated, as evidenced by all the possibilities we have discussed. Often the right thing to do turns on a cost benefit analysis of who the beneficiaries are, how much the solution might cost, and how much the assets are worth, or guessing how much they will be worth. It is important to discuss all your options with an estate planning attorney to make sure that you know what the result will be no matter which option you choose and to revisit your estate plan on a regular basis and particularly when situations change.
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If you’re someone who needs to include Medi-Cal planning in your estate plan, we can help. For more information on what Medi-Cal planning should look like, visit https://absolutetrustcounsel.com/practice-areas/medi-cal-planning/ for even more resources to help get you started.