When I counsel new estate planning clients in my law office on the North Shore of Massachusetts, I tell them to consider their Revocable Trusts as “Will Substitutes,” because they determine the ultimate disposition of their property. While this is a general rule, it is not always true. Often times clients have assets that pass outside of their Wills or Revocable Trusts.
The best examples of this are Retirement Accounts (IRAs and 401(k)s). These Retirement Accounts allow the owner to dictate who will inherit them, by using a special beneficiary designation forms. When completing these forms, clients have two options: to name their Trust, or to name a person.
Naming a Trust
If you’ve carefully set forth your wishes in your Revocable Trust, then you can be sure that your Retirement Accounts will benefit the right persons in the right ways. However, the Tax Code and Treasury Regulations require the Trustee of a standard Revocable Trust to withdraw the entire balance of the Retirement Account within five years of the owner’s death. Unfortunately, taking this money out of these accounts results in a realization of income for tax purposes. So, if you name the Trust as beneficiary, you can provide an inheritance in a thoughtful and protective way, but you may pay more in taxes than if you had named an individual.
Naming an Individual
If you name an individual as the beneficiary of your Retirement Accounts, then that person can withdraw money from the account over their lifetime, according to their life expectancy. By spreading out the distributions, they can minimize their income taxes. However, an individual may not choose to spread out their distributions, and may take the account as a lump sum, resulting in a tremendous tax bill. Furthermore, an individual beneficiary of a Retirement Account could lose the assets to lawsuits, creditors, divorces, addiction, or any other expensive event that life throws their way. If the Retirement account had gone into a Trust, then it could’ve been protected for the ultimate beneficiary.
So What Should I Do?
Well, your specific course of action should be based on your unique circumstances, and should be discussed with an experienced estate planning attorney. But in general, here is what I advise for many of my clients. If you are married, then each spouse should designate the other as beneficiary. I recommend this because spouses have the ability to “roll over” their deceased spouse’s Retirement Accounts into their own. Therefore, they can achieve the ultimate tax deferral during their remaining lifetime. Then, I recommend that the surviving spouse carefully weigh the financial savvy and risky behavior of their next of kin. If they have substantial concerns, then they should lean towards the trust. If they are worry free, then they should lean towards individual beneficiaries.
Fortunately, they can also have it both ways (guaranteed tax deferral and asset protection), but that’s covered more in another post.