As you may know, the person (or persons) designated as the beneficiary of your tax-deferred 401(k) plan, 403(b) plan traditional IRA, Roth IRA and other retirement plans will receive that money when you die. These retirement plan assets are transferred by “operation of law,” which means that your will has no effect on them.
In other words, they pass outside of your will and are considered non-probate assets.
In general, married retirement account owners name their spouses or children as beneficiaries (it may even be required to name a spouse).
But in some situations, you may not want to name a person (or persons) as the beneficiary of your retirement plan. You may want to name a trust.
Here are some examples:
- You may not want the beneficiary to receive all the money in the retirement account at once. A trust will allow they money to be distributed over time.
- An individual may want to name his or her siblings as beneficiaries of a retirement account. But in the event one of the siblings dies, the account holder wants the children of the sibling to receive the money. A trust would allow this type of flexibility.
- You may want to restrict the use of the money by a beneficiary (for example, to pay for college) or to care for a special needs child. Again, a trust would allow this while simply designating the beneficiary on your account would not.
- The bulk of your money is held in retirement accounts and you want to set up a marital bypass trust to be the beneficiary in order to decrease estate tax.
- An individual is remarrying and wants to set up a trust to ensure his new spouse and his children from a previous marriage receive a certain amount of money from the retirement accounts.
In these cases, as well as in other situations, you may be able to meet your goals by designating a trust as the beneficiary of your retirement account(s).
However, naming a trust as the beneficiary of your retirement plan has tax implications.
In general, when a distribution is made from a tax-deferred retirement plan, the amount is taxable in the year it is received.
When a trust is named as the beneficiary of the retirement plan, the plan itself is not transferred. The assets are eventually distributed from the plan to the trust after the account holder’s death, and distributions are taxable at that time.
Therefore, if you are setting up a trust and funding it with retirement plan assets, you need to look at the tax costs and benefits. For example, if you want to leave retirement assets to your spouse and you want to defer taxes for years into the future, it is generally better to name the spouse outright as a beneficiary of the account rather than name a trust as the beneficiary. With a trust, a federal (and possibly state) income tax bill would be due in the year of the retirement plan distribution to the trust while as an outright beneficiary, your spouse has the ability to take a distribution or allow the tax deferral to continue for years.
Naming a trust as a beneficiary of your retirement plan can be a complex transaction. You need to first find out if the plan administrator allows a trust to be a beneficiary. You should also consider alternatives. For example, more emphasis on a properly prepared look-through trust can avoid negative income tax consequences and allow the trust beneficiary to take distribution over years. Consult with your estate attorney or a qualified adviser before finalizing any decisions.