Retirement plan benefits are not generally distributed to beneficiaries named in wills or trusts. Rather, they are distributed to beneficiaries named in Beneficiary Designation Forms (DBF) which state who will receive the retirement plan assets at the owner's death.

 

Definition

For purposes of this article, profit-sharing plans, defined benefit plans, 401(k)s, 403(b)s and IRAs will be collectively referred to as an IRA, but the discussion applies the same to all these plans.

 

One of the biggest mistakes people make with respect to their estate planning is not properly naming beneficiaries of their IRAs.

 

Recent IRS Ruling

A recent IRS ruling shows how not naming beneficiaries properly can cause an immediate income tax on all the IRA assets, rather than having the income taxes deferred over the beneficiary's lifetime.

 

In the ruling, the owner of an IRA had named three Designated Beneficiary Trusts (DBTs) for his three children as beneficiaries of his IRA. The purpose for naming the trusts was to avoid an immediate income tax on the IRA assets when the owner dies and to protect the IRA assets from the children's creditors.

 

The owner moved his IRA to a new institution and signed a DBF naming his estate as beneficiary. Without realizing it, the naming of the owner's estate as beneficiary would cause all the income taxes to come due on the IRA assets when the owner died, rather than deferring the taxes over the children's lifetimes.

 

The owner died and his children, realizing the income tax effect, filed a petition with a state court to retroactively modify the beneficiaries of the IRA to be the three DBTs so the children could receive the income tax benefit of deferring the income on the IRA distributions.

 

The children then filed for a ruling with the IRS to accept the court modification in order to avoid the immediate income taxes.

 

The IRS ruled that they were not bound by the state court's ruling changing the beneficiaries retroactively. In addition, even though the owner's intent was not to change the beneficiaries of the IRA when he moved the IRA to a new institution, the DBF as filed controlled and the owner's estate was the beneficiary.

 

As a result of the IRS ruling, the children had to pay all the income taxes on the IRA assets as of the owner's death.

 

How This Works

Here is an example of how this works.

 

Assume you own an IRA with $500,000 in it. If you name a DBT for your son as beneficiary, distributions are made to your son's DBT over his lifetime. If he has a 50 year life expectancy, the first year would result in a distribution of 1/50 of the IRA (i.e., $10,000) on which income tax would be paid. In the second year, 1/49 of the IRA would be distributed to the DBT and taxes would be paid on that amount and this would continue until all the assets in the IRA have been distributed.

 

If your estate (or a non-qualified IRA beneficiary) is named on the BDF, all the income taxes on the $500,000 are due immediately. If the income tax rate is 45%, $225,000 would be lost immediately to income taxes and your son would only have $275,000 left of the IRA monies.

 

If you would like to discuss how to set up your IRAs so as to minimize the income tax benefits to your children, as well as protect those monies from creditors, contact us.