The impressive rise in the stock market in the last few years has dramatically increased the balances in many individuals' retirement accounts. We are seeing more clients whose primary asset is a retirement plan benefit, including amounts rolled from a company pension plan into an IRA upon retirement. Proper estate planning considers the income and estate tax ramifications of such plans. Unfortunately, many taxpayers and some practitioners fail to realize the importance of a proper beneficiary designation for retirement accounts.

The issue considered here is not the amount or timing of distributions during the owner's life. Rather, it is the designation of the persons to receive the benefits upon the owner's death, and the manner in which they receive them.

There are generally three factors to consider in determining the beneficiary of such accounts: the income tax deferral that is the primary characteristic of these accounts, the effect of potential estate taxes, and the extent to which the owner wishes to retain control of the ultimate disposition of the benefits.

The most common primary beneficiary of a retirement account is one's spouse, and this is generally the best designation for several reasons. First, the spouse can generally rollover the funds into his or her own IRA, and maintain the tax deferred nature of the account. This, of course, allows for faster growth of funds than a taxable account. If the funds are not required to be distributed immediately, imagine the significant growth that would continue to occur within the retirement account if a surviving spouse lives many years after the death of the original owner of the account.

Second, from an estate tax viewpoint, the amount passing to the surviving spouse will generally qualify for the unlimited marital deduction, and therefore pass to the surviving spouse free of estate tax. This is generally desired, except where doing so fails to fully use the estate tax credit of the owner, as further discussed below.

The third factor mentioned above is the extent to which the owner controls the ultimate disposition of the retirement account funds. Naming one's spouse as beneficiary allows the surviving spouse to rollover the benefits into his or her IRA, and then designate his or her own beneficiary and also determine the timing and amounts of distributions. In other words, there is a total loss of control as to the ultimate disposition of the funds. However, where the owner has confidence in the decisions to be made by the surviving spouse, this would not be a problem.

However, if the owner insists upon control of the ultimate disposition of the funds, that can be achieved by a different beneficiary designation, but at the price of potentially higher taxes. This situation commonly occurs where the owner has remarried, but has children from a previous marriage. The owner may desire for the surviving spouse to have the ability to live off of the retirement account during his or her life before passing it to the owner's children. This can be done in the following manner.

First, the owner will create a trust which will provide that the surviving spouse is entitled to distributions from the account for the remainder of his or her life. Upon the death of the surviving spouse, the trust will terminate, and the remaining amounts will be distributed directly to the owner's children. If drafted properly, such a trust can qualify for the estate tax marital deduction as "qualified terminable interest property." However, distributions would have to commence upon the owner's death, thereby forfeiting the potential income tax deferral that is present via a rollover when a spouse is the beneficiary. In summary, this plan gives the owner control and estate tax deferral, but potentially accelerates distributions and therefore income tax on the retirement funds.

Another situation which may call for designation of a beneficiary other than one's spouse is where the owner has no other substantial assets with which to fund a "credit shelter trust" and thereby uses his or her estate tax credit upon death. (This amount currently shelters $675,000, and is scheduled to rise to $1,000,000 over the next seven years.) The trust is created in the owner's Will, and this trust is designated as the beneficiary. The trust could provide for discretionary distributions of income to the surviving spouse and possibly children. The owner has flexibility in the trust provisions.

Under this scenario, the owner maintains control of the assets as well as maximizes estate tax savings. Again, the cost is a loss of some of the income tax deferral. Because a trust is the beneficiary of the account rather than an individual, then the minimum distribution rules will require immediate commencement of distributions upon the owner's death. More importantly, because this built-in income tax will ultimately reduce the amount passing through the trust for the owner's family, this is a poor use of the owner's estate tax credit. For these reasons, use of a retirement account to fund a credit shelter trust should be a last resort.

It's better to name one's children as the beneficiaries rather than the estate

The above discussion has focused on the situation where the owner is married and has children. What about where the owner has no spouse, due to divorce or death, but does have children? Unfortunately, the immediate response of the owner may be to designate his or her estate as the beneficiary. This is generally ill-advised because one's estate is not a "designated beneficiary" under the tax law, and the entire balance in the retirement account must be paid out within five years. This obviously destroys the income deferral advantage of the account.

Generally, a better approach is to name one's children as the beneficiaries. This will usually allow the children to choose to take distributions based on the life expectancy of the oldest child, which should be much greater than five years. Where such a life expectancy is 40 or 50 years, the advantages to keeping the tax deferral working to grow the retirement benefits are overwhelming. Therefore, in this situation, it is generally advisable to name one's children as beneficiaries rather than one's estate. (This recommendation will also generally apply when naming a secondary beneficiary of the account of a married owner who has named a surviving spouse as primary beneficiary.) One disadvantage is that the owner loses the ability to control the timing of distributions to the children.

Generally, it is better to fund charitable bequests with retirement benefits

Designation of beneficiaries also affects the amount of the owner's "required minimum distributions" which must commence after the owner reaches the "required beginning date" ("RBD"). If the owner fails to make the right designation, distributions may occur at a much faster rate than would be required with proper planning. Once the RBD has passed, it is too late to modify the rate of distributions. Therefore, taxpayers who are approaching age 70 should act now to properly plan for distributions.

Another special circumstance is where the owner has charitable motives. Generally, it is better to fund charitable bequests with retirement benefits. Because charities are tax-exempt, the built-in income tax on the retirement funds is eliminated. The owner is then free to leave other assets (which do not carry a built-in income tax) to his or her family members.

This article is only a brief summary of the major issues to consider in designating a beneficiary. Several technical factors have not been discussed. The rules are extremely complex and present a trap for the unwary. Each individual situation must be carefully reviewed. We recommend that all clients review their beneficiary designations to ensure that they meet the individual's goals as well as provide the maximum tax benefits.

©2000 by Gomel & Davis, LLP. All rights reserved.

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