Beneficiary Designations – the Importance of Proper Planning

In the process of preparing their estate plan, many people are surprised to learn that their wills or trusts generally do not control what happens to assets such as retirement plans, IRAs, life insurance, and annuities when they die. Rather, these assets are controlled by beneficiary designations that the person may have signed when opening the account or purchasing the life insurance. Here is a list of important points to consider in making sure your beneficiary designations coordinate effectively with your overall estate plan:

  1. Carefully determine the current status of the beneficiary designation on each retirement account or life insurance policy. Do not assume that a beneficiary designation on one account will be the same on other accounts. If there are multiple retirement accounts, find the beneficiary designation paperwork for each account. Also, applicable law requires that for qualified retirement accounts such as 401k plans (as well as IRAs in some states), the surviving spouse must sign a written consent if the account’s primary beneficiary will not be the surviving spouse.
  2. As life brings change, change your beneficiary designations. For example, upon a marriage, divorce, birth of a child, death of a previously-named beneficiary, or other significant life event, make sure your beneficiary designation on each account is updated.
  3. If a prospective beneficiary is a minor, young adult, has special needs, or has problems with creditors or chemical dependency, then carefully consider whether additional planning is necessary. For example, if a minor is a designated beneficiary under a life insurance policy, then absent other planning, it could be necessary to have a conservator appointed to manage the life insurance proceeds until the minor becomes an adult. However, as legal “adulthood” is 18 in most states, if the conservatorship ends at age 18, then the assets could be prematurely dissipated due to the young person’s inexperience or youthful indiscretions. If a special needs beneficiary is receiving governmental benefits, the receipt of such assets could cause those benefits to be curtailed or eliminated. Finally, if a beneficiary has problems with creditors (including a former spouse), then these assets could potentially become subject to the claims of these creditors.

    In all these situations, if the retirement account or life insurance proceeds are payable to a trust that is specially designed for the intended beneficiary, then many of these problems can be avoided. Any such trust must be carefully drafted in order to obtain the best possible tax results.

  4. Beneficiary designations can also be incredibly important to proper tax planning. When a surviving spouse is named as the primary beneficiary of retirement accounts or IRAs, the spouse can “roll over” the account to his or her own IRA. In addition, if surviving children or other beneficiaries are named as beneficiaries of IRAs, current law allows these beneficiaries to maintain the account in an “inherited IRA,” which in turn allows them to only take required minimum distributions (or “RMDs”) based upon that beneficiary’s life expectancy. Hence, a younger beneficiary could potentially extend the tax-deferral benefits of an inherited IRA for decades following the death of the original IRA owner (this technique is sometimes referred to as a “stretch IRA”). Finally, for a life insurance policy, proper tax planning might include not only structuring beneficiary designations properly, but also causing the ownership of the policy to be owned by an individual other than the insured, or by a trust commonly known as an “irrevocable life insurance trust,” or “ILIT.”


How Safe Is Your Stretch IRA?

It is not hard to find reasons to be nervous about the economy and the health of our retirement nest eggs these days. The equity markets continue their multi-year run of historically high volatility, the national unemployment rate only recently dropped into the single digits and the explosion of home foreclosures continues its downward pressure on housing prices.

Another bleak subject in today’s headlines is the record number of U.S. citizens and companies filing for bankruptcy protection. According to a report earlier this month from the Administrative Office of the U.S. Courts, there were over 1.5 million bankruptcy cases filed in the Federal Courts in fiscal year 2010, up over 13% from 2009 (and five times the number of cases reported in 1980)

During a bankruptcy proceeding, the petitioner prepares a schedule of his or her assets and then the court oversees the liquidation of the assets based on the type of bankruptcy filing. Two of the most common types of filings are a Chapter 13, where a petitioner (usually a corporation) agrees to a payment plan that will reimburse creditors for a portion of the money owed them, and a Chapter 7, where the court will discharge an individual’s debt and the person will essentially start a new financial life. During these proceedings, certain assets of the debtor are protected from creditor claims, these are called exempt assets.

It is important to note that in determining the exempt/non-exempt status of assets, the court must look to both federal and state rules. It is the federal rules which outline the bankruptcy proceeding, yet state laws can also come into play when they involve state protective statutes, state trust statutes, real estate statutes, etc. In the case of the Chapter 7 filings, there are some recent state court decisions that throw into question exactly which assets are exempt from the bankruptcy judgment and these cases are illustrative of the measures that creditors are going to in an effort to reach debtors’ assets in these turbulent financial times. This case law, along with different state exemption laws, should give pause to individuals that are inheriting IRAs and planning on utilizing the stretch-out provisions to take payments over their own life expectancy (called the stretch IRA strategy).

The first two cases are In re Chilton (where a Texas bankruptcy court found that inherited IRAs are not entitled to protection) and In re Nessa, where a Minnesota bankruptcy court came to the opposite conclusion. Further, in In re McClelland, an Idaho court allowed for a state exemption to stand, yet courts in California, Oklahoma and Texas (among others) have disallowed these protections. Finally, in Robertson v. Deeb, a Florida court allowed the state exemption to apply, but then ruled that Inherited IRAs were not protected under the Florida rule due to the changes that happen to an IRA (from a tax standpoint) at the moment it is inherited. These cases illustrate the different impact that state statutes – and the strength of individual arguments in these state courthouses – have on the protections available to an individual inheriting one of these accounts.

The case law is largely silent on this issue in Oregon and Washington, however analyzing the statutes suggests that inherited IRAs may be better protected here than in other parts of the country. 

In Oregon, we look to ORS 18.358(e)(2) which says “a beneficiary’s interest in a retirement plan shall be exempt, effective without necessity of claim thereof, from execution and all other process, mesne or final.” This language would seem to exempt inherited IRAs entirely, however it is worth noting that in Robertson v. Deeb the court spent a good deal of time analyzing the statutory language in Fla. Stat. 222.21(a)(2008) to determine exactly what the Florida legislature meant by the word ‘beneficiary’. Under such analysis, ORS 18.358 may leave the door open to creditors attacking inherited IRAs because the statute defines a beneficiary only as, “a person for whom retirement plan benefits are provided and their spouse”. A court may interpret this language to exclude individuals that inherit IRA accounts and, if that is the case, the statutory protections may not apply.

In Washington, the controlling statute offers more protections. RCW 6.15.020 specifically lists IRA (and Roth IRA) accounts as types of ‘employee benefit plans’ and then declares, “The right of a person to a pension, annuity, or retirement allowance or disability allowance, or death benefits, or any optional benefit, or any other right accrued or accruing to any citizen of the state of Washington under any employee benefit plan, and any fund created by such a plan or arrangement, shall be exempt from execution, attachment, garnishment, or seizure by or under any legal process whatever.”

From a planning standpoint, the levels of protection available to these Inherited IRAs are uncertain and under a lot of scrutiny in courtrooms today. On first reading, the Revidsed Code of Washington offers more concrete protections than the language in the Oregon Revised Statutes, however we have now seen courts across the country develop very different interpretations of the federal and state protections allowed to petitioners’ interests in these inherited accounts. The bottom line? One way to shield these assets from claims, regardless of the state you live in, may be to place these inherited assets into a trust. Consult an estate planning attorney to see if this option may be right for you.