Optimizing Beneficiary Designations for Retirement Plan Benefits

As IRAs, 401(k) and other retirement plans become more popular, it is important for advisors to understand the rules regarding the distribution of plan assets after the death of the IRA owner or the employee.  The timing of distributions from a qualified plan will depend upon whether the decedent has a “designated beneficiary” and may also depend upon whether the “designated beneficiary” is the decedent’s surviving spouse, children or a trust.  Having a “designated beneficiary” may stretch out the period over which plan assets must be distributed; thereby allowing plan assets to remain in the plan longer and continue to grow.  As a financial advisor, your clients will expect you to be familiar with the “designated beneficiary” rules.

The rules for qualified retirement plans are found in section 401(a) of the Internal Revenue Code (the “Code”).  The rules for individual retirement accounts (“IRAs”) are found in section 408(a).  Section 401(a)(9) of the Code provides that a plan is not a qualified plan unless it requires the entire interest of the participant in the plan to be distributed to the participant beginning not later than the required beginning date (the “RBD”).  Section 408(a)(6) provides that rules similar to the rules of section 401(a)(9) shall apply to IRAs.  Generally, the RBD for both qualified retirement plans and IRAs is April 1 of the calendar year after the calendar year in which the participant or IRA owner turns age 70 ½.  Once begun, distributions will generally be made on an annual basis over the life expectancy of the plan participant or IRA owner.  The required annual distribution is determined using actuarial tables contained in the treasury regulations under section 401(a) of the Code.  But, what happens if a plan participant or IRA owner dies before his entire interest in the plan has been distributed?  This is where it becomes important to understand the rules regarding the designation of a beneficiary.

Like any other asset owned by an individual, funds held in a retirement account or IRA pass to a decedent’s heirs after his death.  The manner in which plan and IRA assets pass to a decedent’s heirs depends upon a number of factors.  First is whether the plan participant or IRA owner dies before his RBD.   Generally, if a plan participant or IRA owner dies before his RBD, plan assets must be distributed within five years.  Second is whether the decedent’s beneficiary is a “designated beneficiary”.  The term “designated beneficiary” is defined in section 401(a)(9)(E) of the Code as “an individual designated as a beneficiary by the employee”.  Whether a beneficiary is a “designated beneficiary” is of utmost importance.  If the decedent has a “designated beneficiary”, then the distribution may occur over the life expectancy of the “designated beneficiary”, whether or not the plan participant or IRA owner dies before his RBD.  Third is whether the “designated beneficiary” is the decedent’s spouse.  A spouse may further delay the distribution of plan assets.  In certain circumstances, a trust can qualify as a “designated beneficiary”.  Your clients will depend upon your advice in determining whether and how to choose a ‘designated beneficiary”.

Here are some of the rules regarding the distribution of plan or IRA assets after the death of the plan participant or IRA owner.

Spouses

  • The distribution rules treat a spouse more favorably than any other beneficiary, especially if the spouse is the decedent’s sole “designated beneficiary”. A spouse has a number of options: Like any beneficiary, a surviving spouse may elect to take an immediate, lump-sum distribution of plan assets on a taxable basis or may take annual distributions over a period of time.
  • A surviving spouse may elect to treat the decedent’s account as his or her own; in which case the surviving spouse will be considered the owner of the account for all purposes If the plan participant or IRA owner dies before his RBD, and the sole “designated beneficiary” is his surviving spouse, then distributions may be made over the life expectancy of the spouse, with distributions commencing the later of the end of the calendar year immediately following the calendar year in which the decedent died or the end of the calendar year in which the decedent would have attained age 70 ½
  • If the plan participant or IRA owner dies after distributions have commenced, then, unless the surviving spouse elects to treat the account as his or her own, distributions must be made over the longer of the spouse’s life expectancy or the remaining life expectancy of the owner

Non-Spouses

A “designated beneficiary”, who is not the plan participant or IRA owner’s surviving spouse, has many of the same options as a spouse.  However, if the plan participant or IRA owner dies before his RBD, a non-spouse “designated beneficiary” must begin taking distributions on or before the end of the calendar year immediately following the calendar year in which the plan participant or IRA owner died. A non-spouse “designated beneficiary” cannot wait until the plan participant or IRA owner would have attained his RBD if later.

Trusts

If a trust is named as the beneficiary of a plan participant or IRA owner, then the beneficiaries of the trust will be treated as “designated beneficiaries” as long as certain requirements are met.  The trust must be valid under state law and must either be irrevocable or become irrevocable upon the death of the plan participant or IRA owner.  In addition, the beneficiaries of the trust must be identifiable.  If these requirements are met, then the trust beneficiaries will be treated as “designated beneficiaries”, and distributions will be made in accordance with the “designated beneficiary” rules.

A plan participant or IRA owner has many other issues to consider.  He or she may want to designate more than one beneficiary.  An IRA owner may desire to make charitable distributions from his or her IRA.  The distribution rules are technical in nature and very complex.  Clients need to work with experienced and knowledgeable advisors, who not only know the rules, but can help them to fill out the required forms.  Periodically reviewing your clients’ beneficiary designations to make sure they reflect their current needs and desires and comply with the rules is a good way to maintain contact with your clients and add value.

For more information or helping setting up a retirement plan, contact RMC Group today at 888.599.5553.