There is a difference of opinion among estate planning professionals regarding designating a revocable living trust as a beneficiary of a 401(k) plan or other retirement plan (such as an IRA).

Some of the differing opinions derive out of misconceptions involving the Internal Revenue Code and the income tax. Prior to 2003 there was much concern with regard to naming a trust as the beneficiary of a retirment plan. The concern was that it would be necessary to immediately distribute the retirement plan account to the trust and realize income tax on all of the distribution in the year of death.

Beginning in 2003, the IRS issued a number of rulings that allowed a properly drafted revocable trust to be the beneficiary of a retirement plan account without adverse income tax consequences. In 2005, Congress passed the Pension Protection Act of 2005. That Act allows a revocable trust to be an eligible beneficiary of a retirement plan.

The primary advantage of naming an revocable trust as beneficiary for my 401k or other retirement plan is the ability to control the distribution of the proceeds of the retirement plan in the event circumstances are not as you expected them to be when the retirement plan holder dies. For instance, if an individual is named as the beneficiary of a retirement plan account, and that individual passes away before the account owner dies, then what happens to the retirement plan account? There may or may not be a contingent beneficiary named with the retirement plan administrator. If not, then to whom do the funds get distributed?

To determine the answer to that question it usually is necessary to obtain a copy of the retirement plan documents to learn what the plan document requires. Sometimes the plan document provides that if there is no legitimate beneficiary in existence at the death of the account holder, then the plan proceeds will go to the account holder’s estate. Other plans provide that the retirement account proceeds will be distributed to the heirs of the deceased retirement plan account holder. Those heirs could be a surviving spouse, children of the deceased account holder, or others depending on the statutes in the state where the retirement account plan owner lived at the time of his or her death.

If the distribution is to the deceased account holder’s estate, then the plan proceeds may be subjected to the claims of creditors of the deceased account holder, rather than be distributed to the beneficiary free of the claims of the deceased account holder’s creditors.

Creditor Protection for Retirement Plans and IRAs.

In Florida, for instance, retirement plan proceeds are protected from claims of creditors. However, if the default beneficiary, if there is no surviving named beneficiary, is the deceased account holder’s estate, by distributing the funds to the probate estate those funds will be subjected to the claims of the deceased account holder’s creditors, rather than be distributed to family or loved ones.

Jacksonville estate planning attorney and revocable living trust lawyerCan a retirement plan protect my assets?

The larger potential problem is the distribution of the retirement plan account to the wrong person or to the right person at the wrong time. If you the person named as the beneficiary, or the default beneficiary if there is no proper beneficiary designation, is going through a divorce, or has lawsuits pending, or is incapacitated at the time of the distribution, then it is likely that some or all of the retirement plan proceeds will end up in the hands of someone other than who you wanted to receive the retirement plan proceeds (i.e., the divorcing spouse, the beneficiary’s creditors, or in the case of an incapacity a court-supervised guardianship). None of those options are desirable.

However, if you name a testamentary trust as the beneficiary of your retirement account proceeds, whether that testamentary trust arises out of the probate of a will or the administration of a revocable living trust, then you have the ability to avoid the issues that arise when the beneficiary designation is an individual or individuals. The testamentary trust can avoid the problems of creditor claims against your estate, and avoids the concern that a distribution will go to someone during a time of divorce, incapacity or when creditor issues are present. In other words, you are able to ensure that your retirement plan proceeds actually end up with the beneficiary you intend.

Another issue that can be avoided by naming your trust as the beneficiary of your retirement plan is the event that you and your spouse, or other family member, die in a common accident. Most properly drafted revocable living trusts provide that if both spouses die within a stated period of time (usually between 30 and 90 days), that any distributions that were directed to the surviving spouse lapse, or are voided. If your spouse dies at the same time, or within the stated period of time, as your death, the assets that otherwise would be distributed to or for the benefit of your spouse are redirected to your contingent benefactrices named in the trust document.

However, in the same scenario, if your retirement plan assets are designated to go to your spouse, and your spouse dies with you or within a short period of time after your death, then the retirement plan proceeds “vest” in your spouse immediately upon your death, and then the proceeds are distributed according to who your spouse’s beneficiaries or heirs might be. If you have a blended family, the result could be contrary to what you wanted to accomplish.

What About “Stretch” IRA Provisions?

There is one potential negative consequence of naming your trust as the beneficiary of a retirement plan or IRA. Based on current law (the Obama proposed budget for 2013 might change current law), in certain circumstances a beneficiary of a retirement plan or IRA can elect to “stretch” the distributions of the retirement plan or IRA over the life expectancy of the beneficiary. The “stretch” of the distributions reduces the overall income tax burden from the distributions, and allows the beneficiary to take advantage of the tax deferral provided by the retirement plan or IRA.

If a revocable living trust is a beneficiary of the retirement plan or IRA, the “stretch” provisions require that only the life of the oldest beneficiary be used to determine the “stretch” life expectancy to calculate the distributions. The disadvantage arises where there are multiple beneficiaries of the revocable trust and the age difference between the oldest and the youngest is significant. In that event, the younger trust beneficiaries will be obligated to use the oldest beneficiaries age to determine the “stretch” distributions.

It is also possible that a revocable trust may not have been drafted with the appropriate provisions to allow the use of the stretch provisions. In that event, the withdrawal of the retirement plan account proceeds must be completed within five years of the date of death of the retirement plan account holder.

Certainly, before you name your trust the beneficiary of your retirement plan or IRA, you should consult with an experienced estate planning attorney to determine whether the proper language is present in your trust to allow the use of the “stretch” provisions of the Internal Revenue Code.

What is a Retirement Plan Trust?

You may also want to consider a “Retirement Plan Trust.” An IRT is a trust specifically designed to be the beneficiary of a retirement plan or IRA. An IRT allows the use of each individual beneficiaries’ own age to determine the life expectancy for required distribution calculations. A properly drafted IRT is also designed so that there will be no concerns regarding subjecting the proceeds from the retirement plan to the claims of the deceased account holder’s creditors.

Choosing the Right Beneficiary to Designate

Properly designating the beneficiary of your retirement plan or IRA obviously is very important. You have an incredible array of beneficiaries you can name. There are a host of issues as shown by this chart prepared by a nationally renowned expert on IRA and retirement planning, Robert Keebler, CPA, MST, AEP. You can learn more about designating beneficairies for retirement plan accounts and IRAs at our website on the page entitled “Who Should Be The Beneficiary of my IRAs.”

As you may have determined from the above, there can be significant value to using a trust as the beneficiary of a retirement plan or IRA. There are also some pitfalls associated with that action. To maximize the advantage of your retirement plan or IRA for your beneficiaries, it is well worth the time to consult with an experienced estate planning attorney who can help you determine what is the most appropriate course of action for you to take.

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