How to make beneficiary designations after the Secure Act

By Jesse Hancox and Teresa J. Rhyne | Women on Money & Mindset

“My trust is done, so I’m all set, right?”

As estate planning attorneys, we have had to answer that question many times. If the client has a tax-advantaged account, the answer may be “No!”

What is a tax-advantaged account?

A tax-advantaged account — also called a qualified retirement plan or tax-advantaged retirement plan — is an account that is either exempt from taxation, tax-deferred or offers other types of tax benefits. Tax-advantaged retirement plans include IRAs and qualified retirement plans such as a 401(k) or 403(b) plan.

What a trust does and doesn’t do

A revocable living trust is generally funded with a person’s home and other real estate, bank accounts and other non-retirement financial accounts, such as brokerage accounts.

With a trust, a person states where their assets are going when they die and provides a backup plan just in case the original plan hits a bump in the road. What a trust doesn’t do is control assets held outside of the trust — assets like tax-advantaged retirement accounts. These assets are controlled not by the trust, but by beneficiary designations.

What are beneficiary designations?

Tax-advantaged accounts are not transferred to the trust during the estate planning process and do not become trust-controlled assets. Instead, the account owner completes a “beneficiary designation” form with the plan custodian or sponsor, naming the beneficiaries that will inherit the account when they pass away.

The Secure Act, effective Jan. 1, 2020, changed the rules regarding inherited retirement accounts and generally forced earlier distributions (and thus, tax payments) on everyone except spouses and a few specific persons.

Beneficiaries generally fall into three categories: the person’s spouse, non-spouse people (children) and entities such as trusts and charities. Each type of beneficiary has different options when they “inherit” a tax-advantaged account.

Spouses have the most freedom in that they can consolidate the inherited account into their own tax-advantaged account, they can roll the funds into an Inherited IRA, or take a “lump-sum” payment of the whole account.

People other than spouses: With certain limited exceptions, non-spouse persons that are named as a beneficiary must receive all account assets within 10 years of the account owner’s death.

Entities (including some trusts): Depending on how old the account holder was when they passed, entities are able to take distribution over the expected lifetime of the account holder, as a lump-sum, or within five years of the account owner’s death.

Trusts: Naming a trust as the beneficiary of a tax-advantaged account can solve a lot of problems (avoiding distributions to young beneficiaries, providing assets protection, preventing beneficiaries from cashing out too soon). But the regulations governing trusts as beneficiaries of retirement accounts and how and when the account must be distributed are complicated. You’ll need professional help if you want to name your trust as a beneficiary.

It is important to know if those designated as beneficiaries pass away before the account owner because the whole of the account may become part of the owner’s estate, possibly forcing probate and loss of the account’s tax advantages. Be sure to update your beneficiary designations.

Clare’s story

Clare, a client, wanted her home and family business to be given to her daughter, Clarice. Her living trust owned the home and the business. When Clare passed away, her trustee distributed the home and the business to Clarice, just as planned.

Clare also had a son, Chuck, whom she designated as the beneficiary of her IRA. Sadly, Chuck passed away just before his mother, leaving a son, Jimmy. Unfortunately, Clare didn’t designate her trust as the backup beneficiary to her IRA and it ended up in her estate — which required probate.

Clare had a “pour-over will” which stated that any assets subject to probate be “poured-over” to her trust. After nearly two years and substantial probate fees, the IRA proceeds were finally distributed to the trust.

Furthermore, the beneficiaries under her trust were daughter Clarice and son Chuck, with Chuck’s son Jimmy as the contingent beneficiary if Chuck died. Thus, Clarice ended up with half the IRA in addition to the home and business. That’s not what was supposed to happen!

How to coordinate beneficiary designations

While estate plans and beneficiaries have the same goal of making sure assets go where they are supposed to, they each operate according to a different set of rules.

The specific goals for where trust assets go and where tax-advantaged accounts assets are often not in line. A conversation with your estate planning attorney and a financial adviser is the first step.

Together, the goals for each asset are discussed as well as the various methods to reach those goals. In Clare’s case, either Jimmy should have been named as the IRA’s contingent beneficiary, or the trust should have specified that any IRA accounts that become payable to the trust are to be distributed first to Chuck, and then to Jimmy if Chuck had died.

The trust is also particularly beneficial in that it can act as the universal backup beneficiary for non-trust assets and can avoid letting a tax-advantaged account become part of the estate and curtail the loss of the account’s tax advantages.

The trust doesn’t just have to be a backup plan.

Many clients are now using their trusts as the primary method for distributing their trust and non-trust assets by designating their trusts as the primary beneficiaries of their tax-deferred accounts.

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A well-drafted trust is, of course, capable of distributing the trust accounts according to the plan with the added ability to receive tax-advantaged account assets and distributing them in line with tax laws — all the while preserving the account’s tax advantages. The trust can even plan for more complex issues such as planning for those with special needs, charitable entities and minors; providing creditor protection or unusual family structures.

J.R.R. Tolkien wrote in The Hobbit, “It does not do to leave a live dragon out of your calculations if you live near one.”

Much like Tolkien’s dragons, beneficiary designations should not be left out of your estate planning calculations. Your estate planning attorney and financial advisers will help you prepare a solid plan for your trust assets and non-trust assets alike.

Jesse Hancox is an associate attorney and Teresa J. Rhyne is the principal attorney at The Teresa Rhyne Law Group. Their practice focuses on comprehensive estate planning, trust administration, and planning for business owners.

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