Naming individual beneficiaries as primary and alternative death beneficiaries to a retirement account — e.g., an Individual Retirement Account (“IRA”) or 401(k) retirement — is usually sufficient estate planning for these assets. That is not, however, the only available estate planning approach. Nor is it always the best approach. Let us discuss.

The advantages to naming individual beneficiaries as designated death beneficiaries to one’s retirement accounts are simplicity, avoidance of additional administration expenses, and ensuring maximum income tax deferral over the death beneficiary’s own lifetime.

Tax deferred IRA and 401(k) retirement accounts are all about tax savings. Inside the retirement account, income tax is deferred both on the participant’s original pretax contributions and the earnings until distributions are made. Distributions are required to be made over the participant’s lifetime once the participant reaches 70 1/2 years old.

Good estate planning seeks to ensure that once the participant dies the retirement account (tax shelter) continues to exist and makes required minimum distributions over the death beneficiary’s own lifetime.

Otherwise, the retirement account will be distributed either immediately or during a five year period commencing from the year of the participant owner’s death, depending on whether the participant had attained age 70 and a half years old.

Meanwhile income accumulates inside the inheritted IRA free from federal and state income tax. All distributions, whether made from contributions to the retirement account or from income generated inside the retirement account, are eventually 100% subject to income tax as ordinary income in the year received by the beneficiary.

Naming individuals as outright beneficiaries is safe if the beneficiares are not minors, do not receive needs based government benefits, and do not owe significant debts to creditors (and are unlikely ever to do so). If, however, the beneficiary is a minor, receives needs based government benefits (like SSI or Medi-Cal), or now owes, or is likely later on to owe, large debts then naming a suitable trust as the death beneficiary to receive, accumulate and manage distributions from the inheritted IRA account can be worth the extra expense.

To work, however, the trust must be carefully drafted in order to preserve the maximum income tax deferral associated with the beneficiary’s life expectancy.

Unlike most other trusts, trusts that accumulate distributions from inherited retirement accounts should only ever be distributable to younger alternative beneficiaries when the primary trust beneficiary dies prior to the trust’s termination.

Otherwise, with an accumulation trust that receives distributions from an inherited retirement account, the life expectancy of the oldest possible alternative beneficiary will result in that oldest person’s own life being used as the measuring life for taking required minimum distributions after the participant (owner) dies. The result can be a considerable reduction in the total amount received due to more income taxes being paid.

Reasons for using a trust to receive distributions from the retirement account include avoiding an expensive court guardianship proceeding for a minor; preserving a beneficiary’s eligibility to receive needs based government benefits, that would else be lost if the inherited retirement account were to be counted as an available asset; and protecting the retirement account against the beneficiary’s present and future creditors, who would otherwise be able to levy against the retirement account if it were inheritted outright.

Naturally, if any of these concerns apply then not only should that same beneficiary’s share of any retirement account be held in further trust but so too should that beneficiary’s share of most other inheritance assets.

The foregoing is a simplified discussion of a more complex subject. Anyone confronting these issues should seek the professional guidance of a qualified attorney and a qualified financial advisor. These issues need to be properly addressed prior to death in order to protect the beneficiaries against adverse consequences.

“Serving Lake and Mendocino Counties for nineteen years, the Law Office of Dennis Fordham focuses on legacy and estate planning, trust and probate administration, and special needs planning. We are here for you. 870 South Main Street Lakeport, California 95453-4801. Phone: 707-263-3235.”