Name an Individual as Beneficiary of a Qualified Retirement Plan

As a general rule, it is a mistake to name an estate or trust as beneficiary of a Qualified Retirement Plan (“QRP”) that includes an Individual Retirement Account (“IRA”).  Naming an estate or trust of a QRP generally results in adverse tax and other consequences and eliminates favorable payout options.  

A Designated Beneficiary (“DB”) should be the beneficiary of a QRP.  A DB is an individual who is designated as beneficiary.  If benefits are payable to the participant’s estate, the participant has no DB, even if all beneficiaries of the estate are individuals.  A trust is not an individual; however, if various rules are complied with, you can “see through” the trust and treat the individual trust beneficiaries (for some but not all purposes) as if the participant had named them directly as beneficiaries.  A trust that qualifies as a see through trust is not herein further discussed. 

If an individual is named as DB, the individual has options available to her or him.  The options that are available depend upon whether the individual is or is not the surviving spouse.  If the surviving spouse is the beneficiary,

(1)    the surviving spouse can make a trustee-to-trustee rollover or within 60 days of the IRA payment or distribution, the spouse can “roll over,” to another retirement plan (Spousal Rollover-generally an IRA) the benefits left to her or him or

(2)   if the plan is an IRA, the surviving spouse may elect to treat the decedent’s IRA as the spouse’s own IRA.  Either way, the surviving spouse is treated as if she had funded the IRA.  There are three major advantages to making the spousal rollover or election.

   (A)        Ability to name own beneficiaries, keep IRA going longer.  By making the rollover or election, the surviving spouse can name her or his own beneficiaries for the IRA and give the IRA a longer life-span if children, grandchildren or other younger family members or friends are named as beneficiaries. 

The following favorable payout rules apply if the surviving spouse makes the rollover or election and thus becomes the IRA owner:

If the IRA owner dies on or after the required beginning date (RBD), (usually April 1 of the calendar year following the calendar year in which the individual reaches age 70- 1/2) and designated a nonspouse beneficiary for the account, the IRA balance is paid out over the longer of: (i) the remaining life expectancy of the designated beneficiary, using the beneficiary's attained age in the year immediately following the year of the IRA owner's death, or (ii) the remaining life expectancy of the IRA owner, using the owner's attained age in the year of his death.

... If the IRA owner dies before the RBD, and designated a nonspouse beneficiary for the account, one of two payout methods apply depending on the terms of the IRA: (i) Under the five-year method, the individual's entire account must be distributed no later than December 31 of the calendar year containing the fifth anniversary of his death or (ii) Under the life expectancy method, annual required minimum distributions (RMDs) are made over the beneficiary's life or over a period not extending beyond his life expectancy, and must begin no later than December 31 of the calendar year immediately following the calendar year in which the individual died.

By contrast, if the rollover or election isn't made, the survivor doesn't have the opportunity to name other beneficiaries for the account. Additionally, the balance remaining in the decedent's IRA will be distributed over what remains of the payout period that applied when the surviving spouse began receiving RMDs from the decedent's account. Often, this payout period will be the surviving spouse's life expectancy. The bottom line is that if the IRA remains in the decedent's name, the tax-deferred IRA will have a shorter lifespan than if the spousal rollover or election is made.

   (B)        Required beginning date may be deferred. With the rollover or election, the RBD for distributions is April 1 of the year following the year in which the surviving spouse attains age 70- 1/2.

However, if the IRA remains in the decedent's name, and he or she died before lifetime distributions commenced, then lifetime distributions to the spouse generally must begin by the later of: (1) December 31 of the year following the year in which the decedent died, or (2) December 31 of the year in which the decedent would have attained age 70- 1/2 had he lived.

If the IRA owner died after required distributions began, and the rollover or election isn't made, payouts to the spouse-beneficiary must begin in the year following the IRA owner's death.

Thus, a surviving spouse who is younger than the decedent can defer the start of the payout period by making the rollover or electing to treat the decedent's IRA as her own.

   (C)       More favorable RMD rules. After the rollover or election, the receiving IRA is treated as if the surviving spouse had funded it. When the surviving spouse attains the RBD, she can compute RMDs using the uniform life expectancy table for IRA owners age 70 and older.  Note that a separate lifetime distribution table applies if the spouse is more than ten years younger than the IRA owner.  

Young surviving spouses. If the surviving spouse is younger than age 59-1/2, the rollover election could have a significant disadvantage: Once the spouse elects to roll over the decedent's IRA into his own IRA, pre-age-59-1/2 withdrawals from that IRA generally will be subject to the 10% penalty tax on top of regular income taxes.

By contrast, if the rollover election is not made, pre-age-59-1/2 withdrawals from the decedent's IRA will not be subject to the penalty tax.  Distributions made to a beneficiary on or after the death of the IRA owner are excepted from the 10% penalty tax. Thus, if the surviving spouse winds up tapping the decedent's retirement funds before attaining age 59-1/2, the rollover election could result in imposition of the 10% penalty tax.

IRA payout strategy for the younger spouse. The surviving spouse should keep the entire IRA balance in the decedent's name until the spouse attains age 59-1/2. This way, any withdrawals before that age will be penalty-tax-free. When the spouse attains age 59-1/2, she can roll over the IRA into an IRA in the spouse's own name. A surviving spouse beneficiary's election to treat the decedent's IRA as her own can be made any time after the individual's date of death.  In other words, the fact that the surviving spouse takes distributions from the decedent's IRA before the survivor attains age 59- 1/2 won't affect her ability to make a rollover after age 59- 1/2.

A non-spouse individual beneficiary is not permitted to roll over tax free to IRA any portion of a distribution from an eligible retirement plan as a result of the death of the participant.  However a direct transfer of funds from one IRA trustee to another IRA trustee (a “trustee-to-trustee transfer”) does not constitute a taxable payment or distribution to the participant and is not a rollover contribution regardless of whether the bank trustee initiates or the IRA participant directs the transfer of funds. 

Example:  Before she died, Mom designated Son and Daughter as equal beneficiaries of her IRA.  Son will attain age 50 this year and wants to invest the inherited IRA in a money-market fund.  Daughter will attain age 44 this year and wants to invest the inherited IRA in an asset-allocation-type mutual fund.  If the IRA is left as-is, the payout for each child will be based on Son’s life expectancy.  However, if Son and Daughter timely direct the IRA trustee to split Mom’s IRA into two equal inherited IRA’s, Son’s payouts would be based on his life expectancy and Daughter’s on her life expectancy.  Because Daughter’s life expectancy is longer than Son’s, her payouts will be made over a longer period of time than his.  Son can invest his half of the IRA in a money-market fund, and Daughter can invest her half in the mutual fund of her choice.

If Mom died before her required beginning date, then RMD’s must be either

A.    Made over the beneficiary’s life expectancy, but only if distributions begin on or before December 31 of the year following the year in which the IRA owner died or

B.    Entirely distributed by December 31 of the fifth year following the IRA owner’s death.

If Mom had not designated a beneficiary, then the account must be entirely distributed by December 31 of the fifth year following Mom’s death.

If Mom died after her required beginning date, the RMD’s must be made

A.    Over the beneficiary’s remaining life expectancy or,

B.    if longer, Mom’s remaining life expectancy. 

If Mom had not designated a beneficiary, then the account must be distributed over Mom’s remaining life expectancy. 

In summary, name an individual as the beneficiary of a QRP.  Do not name an estate or personal representative of an estate as beneficiary of a QRP.  Unless the trust is a see through trust, do not name a trust as beneficiary of a QRP.  If you wish to name a trust as beneficiary and you are not familiar with the see through trust rules, retain an attorney experienced with the see through rules to draft the trust and advise you as to naming the trust as beneficiary of the QRP.  Upon the death of the owner of a QRP, immediately request the plan administrator of the QRP to advise you in writing of all the options available to the beneficiary of the QRP. 

Bill Belcher is a Partner at Poyner Spruill LLP.  He practices in the areas of estate planning, estate administration, elder law, taxation and business transactions. He has substantial experience in a variety of trust and estate matters including estate planning, administration and will contests, tax planning for individuals and closely held businesses, and organizing and advising charitable organizations.  Bill may be reached at 704-342-5318 or by email at wbelcher@poynerspruill.com.