More and more, the bulk of clients’ net worth lies in individual retirement accounts (IRAs), 401(k)s, pension plans and insurance products. The law deems such assets “non-probate,” because properly completing beneficiary designations on these assets causes them to pass to the beneficiary listed on the account, not with the individual’s probate estate. Lawyers must ensure their clients properly draft beneficiary designations for non-probate assets, as they impact not only a client’s tax bill but a client’s estate plan.
• Naming the estate as beneficiary. A serious problem in beneficiary designations occurs when a client lists her estate as a beneficiary of non-probate asset. If a client lists an estate as the beneficiary, the asset must go through probate; it also is subject to attachment by the estate’s creditors.
In addition, when a client lists an estate as the beneficiary of a qualified plan — a plan that has special IRS tax benefits — she can lose any benefits allowed when recalculating required minimum distributions (RMDs); that’s because Internal Revenue Code §401(a)(9)(B)(ii) mandates paying out RMDs over five years if RMDs have not begun at the time of the participant’s death. That’s in contrast to the deferral of the payment of income tax over the beneficiary’s lifetime.
• Naming a trust as beneficiary . Lawyers easily can accomplish a client’s desire to name a trust as an insurance policy’s beneficiary. The beneficiary designation on an insurance policy can be a specific trust or the trustee named in a client’s will, resulting in the proceeds from the policy avoiding probate and creditor attachment.
But leaving a qualified plan, such as an IRA or 401(k), to any trust requires a great deal of caution. Although stretching the income tax payable on an IRA over the beneficiary’s life is a valuable tool, sometimes the client should leave a qualified plan’s proceeds to a bypass trust for estate-tax planning purposes.
In potentially taxable estates, the lawyer must review all assets of a client’s estate to determine whether the income tax deferral of leaving qualified plans to an individual beneficiary exceeds the benefits of funding the bypass trust with qualified-plan assets. If most of a client’s net worth is in a qualified plan, disclaimers become a powerful and flexible tool for the surviving spouse.
A disclaimer provided under Internal Revenue Code §2518 and either Texas Probate Code §37A or Texas Trust Code §112.010 allows an account beneficiary to treat the funds as if he never received them, so long he executes and files a written disclaimer within nine months of the death of the individual owning the funds.
Listing a spouse as the primary beneficiary of a qualified plan and a bypass trust as the secondary beneficiary of the qualified plan gives the surviving spouse some flexibility. The surviving spouse can take a second look at the assets the deceased’s spouse’s taxable estate will include. If a lawyer determines that it’s better to leave the funds to the bypass trust, as opposed to rolling the assets of the qualified plan over into a spousal IRA, the surviving spouse can file a qualified disclaimer, leaving the funds to the bypass trust.
Sometimes a client may want to leave funds from a qualified plan to a trust to benefit descendants. The Internal Revenue Service requires that a trust qualify as a designated beneficiary in order to obtain the benefits of recalculating required minimum distributions (RMDs) over a beneficiary’s lifetime.
Treasury Regulations §1.401(a)(9)-4, A-5(b) state that to qualify as a designated beneficiary: 1. A trust must be a valid trust under applicable state law; 2. the trust must be irrevocable or will by its terms become irrevocable upon the participant’s death; 3. the beneficiaries of the trust must be identifiable from the trust instrument; and 4. a copy of the trust instrument must have been provided to the plan administrator by Oct. 31 of the year following the participant’s date of death.
Several types of trust qualify as designated beneficiaries, including a conduit trust, an accumulation trust and a toggle trust. A conduit trust passes all RMDs immediately to a beneficiary in each year the law requires RMDs. An accumulation trust allows accumulation of RMDs within the trust, instead of distribution; however, it’s more difficult to make an accumulation trust succeed, because determining RMD payout requires taking into account the trust’s primary and residuary beneficiaries. And a toggle trust is allowed under IRS Private Letter Ruling 200537044, which permits a trust protector — an appointee whose power is limited to amending the trust to ensure that trust purposes are fulfilled — to determine whether a conduit trust or accumulation trust is more effective and to reform the trust within a limited time frame.
Lawyers much use extreme caution when drafting designated-beneficiary trusts. Even adding a power of appointment or a charity as a beneficiary can thwart efforts to obtain designated-beneficiary status for a trust. Earlier this year in Private Letter Ruling 201021038, the IRS showed its stringency in applying the designated-beneficiary rules; it did not respect retroactive reformation of an accumulation trust containing powers of appointment to comply with the designated beneficiary rules, resulting in a loss of favorable tax treatment.
The lesson for lawyers to learn? They must employ careful planning and expert drafting to ensure that non-probate assets pass properly within a client’s estate plan. Errors in drafting estate plans or completing beneficiary designations can lead to increased estate taxes, loss of the ability to stretch out RMDs and attachment of a beneficiary’s assets by creditors.
Cynthia D. Hurley is the resident partner of the Frisco office of Jordan, Houser & Flournoy. She is board certified in estate planning and probate by the Texas Board of Legal Specialization.