Planning for Retirement Benefits: Get it Right the First Time

Retirement assets comprise a large portion of most Americans’ total wealth. By March 2015, retirement assets hit $24.9 trillion. That’s a lot of money! The key to maximizing and maintaining that large chunk of your clients’ wealth is to keep the money in the retirement plan for as long as possible.

Two Reasons

There are two reasons it is normally best not to withdraw retirement assets for as long as possible.

Asset Protection

The first reason is asset protection. As long as the assets are in a retirement plan (like a 401(k)) during the client’s lifetime, the assets are completely protected from creditors in bankruptcy under the federal Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCA”). If the assets are in an IRA, instead of a retirement plan like a 401(k), the assets are protected in bankruptcy up to a minimum of $1 million (adjusted for inflation) pursuant to the federal law. There may be further protection from creditors under state law. However, under the U.S. Supreme Court case of Clark v. Rameker, asset protection under BAPCA does not extend to inherited retirement assets. The protection applies only during the lifetime of the “Participant,” in other words, the person who contributed the assets.

Income Taxation

The second reason is income taxation. Retirement assets, including all growth on the assets, are subject to ordinary income taxation upon withdrawal (unless the assets are in a Roth 401(k) or Roth IRA). This is true even if the growth on the assets is due to capital appreciation which would have been taxed at a lower capital gains tax rate if held outside a retirement account. Depending upon the client’s income tax bracket, income taxation can reduce the assets by more than 40%, not including any state income tax.

During your clients’ lives, they can defer the taxes by keeping the assets in their retirement accounts for as long as possible, while being sure to withdraw their Required Minimum Distributions (RMDs) after reaching age 70 ½. But, after the client’s death, the retirement assets may need to be withdrawn in as little as five years, depending upon the beneficiary designation.

But, if the client names a young beneficiary to receive the retirement assets, the assets may be able to be withdrawn over an extended period of time. For example, if the client names a beneficiary who is age 19 at the client’s death, the beneficiary may pull the assets out over the beneficiary’s 66-year life expectancy. However, there are challenges to naming a young beneficiary outright. A guardianship may be required for a beneficiary under the age of majority. Also, most clients would be reluctant to put a large amount of assets in the hands of a young beneficiary due to a young beneficiary’s lack of discretion and maturity. Also, if the beneficiary is named outright, the assets would have no asset protection under federal law because of the Clark v. Rameker case. This is particularly troublesome given the increased asset protection risk given the young beneficiary’s lack of discretion and maturity.

Solution

So, what’s the solution? The client may name a trust for the beneficiary as the designated beneficiary of the retirement assets. If the client names a trust for the beneficiary as the designated beneficiary, rather than the beneficiary in their individual capacity, there would be no need for a guardianship and, if the trust is drafted correctly and other requirements are met, the IRS will “look through” to the trust’s beneficiaries’ ages to determine the Required Minimum Distributions. That solves the stretch part of the problem. But, what about the creditor protection? If the trust is drafted as a fully discretionary trust with a third-party trustee, the assets should gain asset protection, as well.

The client can change their beneficiary designation while they are alive. However, after they are dead, even a court proceeding to modify the beneficiary designation is unlikely to achieve the intended result. In three Private Letter Rulings, 201628004-201628006, a taxpayer’s representatives sought a ruling from the IRS. After the taxpayer’s death, the taxpayer’s representatives went to court to reform the taxpayer’s beneficiary designation to name trusts as the beneficiary, rather than the taxpayer’s estate. The representatives were successful in getting a state lower court order changing the beneficiary designation.

However, the IRS refused to recognize the court order as changing the “designated beneficiary” of the retirement assets. (Under the U.S. Supreme Court case of Commissioner v. Bosch, the IRS is not bound to respect a state court order impacting federal tax matters, unless the ruling has been issued by the highest court in the state.) Thus, in this case the client was stuck with the unreformed beneficiary designation for the determination of the applicable withdrawal period and the Required Minimum Distributions. In this case, this resulted in the estate of the deceased client as the designated beneficiary, resulting in withdrawals of the retirement assets based on the “five-year rule.”

Your clients can make sure their beneficiaries are protected from creditors and income taxation that is more rapid than necessary by using a specially-designed trust as the designated beneficiary.