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Creative Ways to Designate Beneficiaries of Tax-Qualified Retirement Plans

By Frieda Gordon

The need for careful planning in the area of retirement benefits, particularly IRA'S and tax qualified pension plans, both as to after-death and pre-death treatment of options for the alternate payee is a fact of which family law attorneys must be aware. With regard to deferred taxation of employment benefits, the designation of beneficiaries is critical not only to the proper allocation of community property but to careful pre-death tax planning and this issue reaches more than simply how to draft a viable QDRO. It is clear that the need for careful tax planning in the area of retirement benefits, particularly IRA'S and qualified pension plans, both as to after-death and pre-death treatment of options for the alternate payee is a factor of which family law attorneys and estate planning attorneys must be aware.


Unless careful estate tax planning is accomplished, as to a married couple, on the second death, or in the event a person is unmarried at the time of death, the estate, gift and income taxes can approach 80% of the size of the estate. It is often advised that party with such assets try to arrange for his or her estate to pay any estate taxes outside of the assets in the community property IRA or to have the tax taken out by way of a monthly pay-out. Similarly, in dividing up the marital estate at time of divorce, it is important to be aware of what the tax implications of assigning rights and benefits to the non-participant spouse are and adjusting the amount of the benefit to reflect the difference in actual value to the beneficiary. By advising a client as to how to properly designate the beneficiaries to the client's estate plan, the attorney may be saving the client many thousands of dollars in tax consequences. Often times, because the payout can be structured to be delayed over 20 to 30 years, there will be little or no tax consequence for the beneficiary. In fact, it is almost always preferable to leave the plan benefits to a spouse whenever possible, whether awarded pursuant to a Marital Settlement Agreement or by testamentary disposition, because owning the benefits, rather than receiving some other asset in kind, will give the most lifetime flexibility to that spouse so that he or she may invest the benefits as he or she wishes and control the tax consequences of its use.

Where most of the assets are in an IRA and there is otherwise less than the maximum amount in the balance of the estate which would permit the beneficiary to take advantage of the statutory spousal deduction, there is little that a financial planner can do to avoid paying taxes on the withdrawals. However, although obviously not a popular choice among happily married spouses, in such a case, it might be financially better to obtain a divorce and have the benefit of a Qualified Domestic Relations Order, which will, by its terms, parcel out the benefits in insubstantial increments, rather than lose much of the IRA to taxes because, by law, the IRA must be entirely distributed to the beneficiary within five years after the death of the original owner of the IRA.

On the other hand, whether at the conclusion of a divorce or other family law proceeding or while discussing various estate planning options with a client, it is important to understand a few other fundamentals of the tax implications regarding IRA rollovers in order to properly advise the client. For example, if it is not the case that the bulk of the estate's assets are held in an IRA, and the spouse is not already 59Ÿ, a rollover to a spousal IRA will allow independent choices by the spouse after the first death and allow the use of the joint life expectancy to minimize the pay-outs. In such a case, recalculating the life expectancy as to the Participant only, with the spouse as joint beneficiary makes the most sense, because it will pay out over the Participantês life much more slowly. Another option is to roll over the balance upon the Participantês death and start a new calculation upon the death of the Participant. This practice will allow the use of the disclaimer option as part of the estate plan upon the first death. Furthermore, if the non-participating spouse dies first, then the trick is to use their joint life expectancy, which will also slow down the payout to the Participant.

An important term to understand is commonly referred to as "RBD," or "Required Beginning Date. The required beginning date means the first April to follow the Participant's reaching the age of 70 years. If the first death of a married couple occurs before the required beginning date, there will be no current estate tax, unless the spouse is not a U.S. citizen. If the first death occurs after the required beginning date, a spousal designation is still favorable because the spouse can take a lump sum payment if the plan permits and create a new rollover to prolong deferral.

Another more obvious solution to the tax problems caused by the designation of beneficiaries to retirement plans is to utilize the predesignation of children as beneficiaries after the first death, which lengthens the income tax deferral, allows for an unquestioned marital deduction and eliminates the need for spousal consent for qualified plans. This device provides protection from neglectful planning by avoiding the mandatory 5-year distribution requirement if the spouse dies before payments are to begin and allows for the availability of a tax deferral over the beneficiary's life expectancy.

The fifty percent interest in the pension benefits which belong to the spouse of the Participant is only an expectancy, or a terminable interest with which the spouse can do nothing. If the spouse cannot accelerate the payments, the life expectancy drops to zero on the second death, causing rapid income taxation. Lawyers should assist Participants in considering their recalculation options carefully. The Participant can always recalculate and should, unless ill, but only spouses can elect to do so. Thus, the recalculation option is a bad idea if the beneficiary spouse will die soon after, because the beneficiaries will have to pay all of the income tax immediately. Recalculation is good for retirement planning, but bad for estate planning, if someone other than a spouse is named as beneficiary of a QTIP or credit shelter trust. Recalculation by the participant is usually recommended except if the non-participant spouse dies first, because the mistake cannot be corrected after the death of the Participant.

Life insurance owned and purchased by a tax qualified retirement plan may be a good way to pay for the taxes which will be owed by the beneficiary of such a retirement plan. Life insurance, if appropriate, can be carefully put into a sub-trust within a qualified plan and thus allow the proceeds of the plan to escape estate taxation. If not needed for living expenses, utilizing the pension benefits to buy life insurance can be done without having to use the sub-trust technique. If there are heirs whom the Participant wishes to benefit from the plan besides the spouse, it is often suggested to leave other assets and/or life insurance to the children and the retirement plan to spouse, or name the QTIP ("Qualified Terminable Interest Property") trust as the beneficiary. Generally, it is preferred not to name a trust as beneficiary in order to be able to leave the trustee with the maximum amount of investment flexibility. However, in this case, the distribution can be based on the beneficiaries' combined life expectancies, thus delaying until the beneficiaries are at a reduced income level the tax consequences of the gift.

The Internal Revenue Service's Qualified Joint Survivor Annuity rules create an automatic QTIP election under Internal Revenue Code Section 2056(b)(7)c(ii). The Code provides that, if no lump sum option is available to ensure a marital deduction, the IRA may qualify as a QTIP itself. If not, it may be possible to make the payments directly to a properly drafted QTIP trust. Clearly, naming a beneficiary who can take life expectancy-based pay-outs is important. If there is no spouse, and benefits need to be left to children or grandchildren, the income tax deferral is more important to the children than to the grandchildren, because the income tax bracket is higher if the generation-skipping tax is not payable.

Beneficiaries owe extra income taxes on distributions made solely to pay estate taxes. This is satisfactory if the estate beneficiaries are the same as the plan beneficiary. But, plan beneficiaries should be responsible for all estate taxes on plan benefits, even if that increases their income tax. Another option would be to explore the possibility of making the estate the beneficiary of a specific dollar amount of plan benefits which is sufficient to reimburse the estate for estate taxes of any kind plus income taxes thereon. Increasing marginal income tax rates and lowering interest rates both have the effect of reducing the advantages of benefit payment deferral. However, there is a bigger impact from estate taxes and, therefore, the general principle of income tax deferral has to be examined carefully.

To find the best tax-saving plan for your client, it will be beneficial to run the numbers when writing estate plans just prior to the required beginning date and, once again, after either death. It may be helpful to use a computer program such as CCH Brentmark Pension Distribution Tax Planner to do the calculations. This surface look at the particular advantages and disadvantages of tax and estate planning relative to deferred income is frightening at best. If the issue arises in one of your cases, it is suggested that you contact a certified tax attorney just to be sure that you have covered all bases.