IRAs, 401(k)s and other tax-deferred retirement accounts allow your savings to grow tax-free until you retire. The year after you become age 70 ½, you must begin taking required minimum distributions from your retirement accounts, and you will pay ordinary income taxes on all distributions. The rest of the money that stays in your account continues to grow tax-free until you distribute it out of the account. If you die before depleting your account, the balance of your account will go to the beneficiary you have named.
Naming the right beneficiary is critical. Most people want to continue the tax-deferred growth for as long as possible, paying the least amount in income taxes. This is called “stretching out” the account. The required minimum distributions after you die will be based on the new beneficiary’s age and life expectancy, so the younger the beneficiary (such as a child or grandchild), the longer the stretch-out potential.
Naming a person as a beneficiary on your retirement account has several disadvantages, including:
- If the beneficiary is a minor, distributions will need to be paid to a guardian; if no guardian exists, one will have to be appointed by the court.
- A beneficiary over the age of 18 can do whatever he/she wants with this money, including taking distributions larger than the required minimum or even cashing out the entire account and destroying your carefully made plans for long-term, tax-deferred growth—not to mention the substantial amount of income taxes that would be due on a large distribution.
- Your retirement account will be available to the beneficiary’s creditors, spouse and ex-spouse(s).
- There is the risk of court interference in the form of a conservatorship, if your beneficiary becomes incapacitated.
- Ownership of the account could cause a beneficiary with special needs to lose valuable government benefits.
- If your beneficiary is your spouse, he/she will be able to name a new beneficiary after your death and is under no obligation to follow your wishes. This may not be what you want, especially if you have children from a previous marriage or you feel that your spouse may be too easily influenced by others after you are gone.
Naming a trust as beneficiary instead will give you more control over, and protection for, these tax-deferred accounts. It should be a separate trust designed specifically for this purpose. Because of the rules governing naming trusts as a beneficiary it should not be part of your revocable living trust or other trust. For this reason, these trusts are often called “stand-alone retirement trusts.”
Instead of required minimum distributions being paid directly to your beneficiary, they will be paid into the trust for the benefit of your beneficiary. The trust will then pay out trust assets to the beneficiary according to your instructions (for example, for higher education expenses, down payment on a home, etc.)
Specific benefits include:
- No guardian is needed for minor children and there is no risk of court interference (conservatorship) at the beneficiary’s incapacity. That’s because a trust, not the individual, is the named beneficiary.
- Your beneficiary is prevented from cashing out or taking larger distributions, assuring the continuation of tax-deferred growth.
- The account itself is protected from creditors and predators, even from divorce claims.
- You can name successor beneficiaries in the trust document and keep control over who will receive the proceeds if your initial beneficiary should die before the account is fully paid out.
- The trust can be used to provide for a beneficiary with special needs. The trustee can provide for certain needs of the beneficiary as they arise without jeopardizing eligibility for needed government benefits.
In order to be accepted by the IRS, the trust must meet very specific requirements, and should be designed and written by an attorney who has experience in this area.
You’ve worked years to accumulate your tax-deferred plans. Naming the right beneficiary can preserve and continue the tax-deferred growth long after you’re gone, protect the assets from creditors and the courts, and provide for your loved ones the way you want.