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Bad News, Good News

Retirement plan expert Natalie Choate answers reader questions about an intestate estate and how a lump sum decision would affect a SOSEPP.

Natalie Choate, 10/12/2012

Every day I answer questions for my readers and seminar attendees. Sometimes I have good news (when the answer is "there is no problem!") and sometimes not (as in the following case).

Question #1: Bad News: We are involved in a tragic situation of a young father's death. One of the many sticky problems involves the decedent's retirement benefits. "Father" (in his mid-40s when he died in a car crash) had a 401(k) plan at work and an IRA. He wanted to leave these benefits and his other assets in trust for his three children who are all minors. His attorney had drafted the trust as well as the necessary beneficiary designation forms, will, and other estate planning documents. "Father" had all these documents for review, but despite frequent reminders and urging from his attorney, his accountant, and his financial planner, he had never signed them when he died. So he died intestate. The IRAs have no beneficiary (default beneficiary is the estate) and the 401(k) plan's beneficiary designation form still names the decedent's ex-wife from whom he had been divorced for over three years. Is there a way to get the retirement benefits into an "inherited IRA" for the children? Can the estate disclaim the benefits in some way that would cause them to pass to the children?

Answer: The short answer is no.

The designation of the ex-wife as beneficiary is still valid. Even if applicable state law would automatically revoke a testamentary disposition in favor of an ex-spouse (that's what happens in many states), neither state law nor any private agreement between the divorcing spouses would be binding on the plan administrator of an "ERISA" plan (such as a 401(k) plan). So unless there was actually a "qualified domestic relations order" (QDRO) that was served on the plan, the ex-wife will receive the 401(k) plan benefits. If the decedent and his ex-wife had agreed as part of their divorce that she would not get those benefits, his executor can bring some kind of lawsuit to enforce that agreement against the ex-wife, unless the ex-wife is willing to cooperate and voluntarily waive her claim to the benefits.

Regarding the IRA benefits that are payable to the estate, those will be subject to the "five-year rule," meaning that all benefits must be distributed out of the IRAs within five years after the decedent's death. An estate is not a "designated beneficiary" so the life expectancy payout option is not available for benefits payable to an estate. In my opinion, the estate can transfer the inherited IRA, intact, to the children, but that will not extend the payout period beyond five years. The IRS has ruled that an estate cannot "disclaim" retirement benefits payable to it.

Of course it will probably be necessary to probate the estate in order to have someone (the executor) who is recognized as being legally entitled to the benefits.

If the decedent had taken care of his estate plan, probate might have been totally avoided, the ex-wife could have been omitted as a beneficiary, and all of the retirement benefits could have been safely transferred to an inherited IRA payable to a trust for his children, over the life expectancy of the oldest child. But that is not to be. Instead, between probate expenses, accelerated income taxes, and the claims of the ex-wife, this father's minor children will have much less money available for their support and education than they otherwise would have had.

Death sometimes comes a little earlier than expected. Are all your clients' estate plans up to date? How about your own estate plan?

Question #2: Good news. "Janet" left her employment at Fast Car Company eight years ago, at age 51. She initiated withdrawals from her former employer's retirement plan using a "series of substantially equal periodic payments" (SOSEPP). She has been faithfully receiving payments ever since, on the first of each month. She will reach age 59½ on Oct. 10, 2012, shortly after she receives the Oct. 1 monthly payment.

However, the Fast Car Company is terminating its retirement plan and has offered her a lump sum payment in satisfaction of all her rights and benefits. The lump sum will be paid Oct. 31, 2012. In September 2012, before she reached age 59½, Janet signed a paper electing to receive that lump sum. Does her signing this election before reaching age 59½ constitute a "modification" of the SOSEPP, retroactively invalidating her entire "series" of payments?

Answer: Again the short answer is "no," but this time a "no" is good news.

Generally, receiving a retirement plan distribution prior to age 59½ results in a 10% "additional tax" (or penalty) on the "premature" distribution. However, there are numerous exceptions to this general rule, and one exception is for any payment that is part of a SOSEPP. But one of the conditions of a SOSEPP is that there must be no "modification" of the series until the later of the individual's attaining age 59½ or the fifth anniversary of the beginning of the series. Any "modification" of the series during this "no mods" period would invalidate the entire SOSEPP and make all of the prior series payments retroactively ineligible for the exception.

In Janet's case, therefore, her series payments must not be modified prior to Oct. 10, 2012, the date she attains age 59½ (because it has already been more than five years since the series started). After Oct. 10, 2012, she can modify the series any old which way--she can stop the payments, or increase or decrease them, or take a lump sum of the entire remaining balance. There will be no penalty involved and no retroactive disqualification of the SOSEPP.

It doesn't matter what Janet signed or agreed to before she attained age 59½ with respect to payment of her benefits after she attains that age. As long as the payout she requested is not going to occur until after the end of the no-mods period, the date she elected it should be completely irrelevant.

What do practitioners say about Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011)? "I sleep with your book under my pillow." "We regard your book as the ultimate authority." "I wish more people wrote books the way you do." "Your book has been a tremendously valuable resource to our firm." "I have found this book extremely helpful." "We have read and used it in many cases already." "It's paid for itself already." "I ordered these for our company last week, and everyone loves it!" "GREAT BOOK!" To find out why your colleagues (and competitors) are raving about Life and Death Planning for Retirement Benefits, visit www.ataxplan.com.

Resources: Regarding how to handle inherited retirement benefits, see Chapter 4 of Natalie Choate's book Life and Death Planning for Retirement Benefits (www.ataxplan.com); for cleanup strategies for such benefits see ¶ 4.6. Regarding the 10% penalty on "premature distributions," the SOSEPP exception, and the "no-modifications period," see Chapter 9 of Life and Death Planning for Retirement Benefits.

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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