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The Biggest Mistake in Estate Planning for Retirement Benefits

The most common tragedy is the planner who did not take care of the client's beneficiary designation form.

Natalie Choate, 04/11/2014

Although practitioners worry about whether they have gotten the latest, most sophisticated estate planning device for their clients (Family partnership! Rolling short-term GRAT! Installment sale to defective grantor trust!), too many miss the basics. The most common tragedy I see is the planner who did not take care of the client's beneficiary designation form. 

The beneficiary designation form should not be an afterthought, something to mention to the client as he or she walks out the door after signing the will and trust. Here are true, sad stories--facts modified to protect privacy--that I have heard in the last few weeks. In each case, the person writing to me erroneously thinks I have a quick cleanup for the mess. I usually don't. The cleanup should have been to not let this happen in the first place. 

Question: Our client died leaving his IRA to the trust we had prepared for him. It was a standard "credit shelter trust," under which income is paid to wife for life, remainder outright to his three children who are all adults. When he signed the trust and the will that went along with it, we advised him not to name the trust as beneficiary. We told him to name his spouse as beneficiary of his IRA. At that time the federal estate tax exemption was $2 million and his total assets were $4 million of which $2 million was in an IRA. When he died, the exemption was $5.25 million. Then we discovered he did not follow our advice--he named the trust as beneficiary. How can we get the IRA out to the wife and children and qualify for a stretch payout? 

Answer: You can't. This family is unfortunately stuck with an IRA that will now be distributed out entirely to a trust over the life expectancy of the widow (at best). There will be no spousal rollover, and the IRA distributions retained in the trust (which the trust terms will require for most of the benefits) will be taxed at high trust tax rates. 

There will be much less for the widow to live on, and much less for the children to inherit, potentially, than would have been true if the IRA had been payable to the wife and she had rolled it over to her own IRA. Naming the trust as beneficiary has caused loss of the "stretch payout" to the children over their life expectancies (after wife's death), which potentially they could have had as beneficiaries of wife's rollover IRA, and that now will not exist. So the retirement benefits will be taxed sooner and at a higher rate (probably) than if the benefits had been paid directly to wife or children or partly to each. And for what? To achieve estate tax savings, a goal that is completely unnecessary in this case due to the increased federal estate tax exemption and/or portability of the estate tax exemption. 

Moral for planners: The estate planning attorney should draft, or at the very least review, the beneficiary designation for each significant retirement plan the client owns. Do not leave this step up to the client! Yes it's a pain in the neck because every employer and every IRA provider has different forms and different rules for their beneficiary designation forms. That's not an excuse to allow a significant asset to go to the wrong beneficiary at the client's death! 

Question: Our client Mabel updated her estate plan in 2012. She signed a new will and trust. The new trust created the "Smith Family Charitable Foundation," which was basically identical to the "Mabel Charitable Trust" that she had in her prior documents. Unfortunately she did not change the beneficiary designation for her IRA. At her death, it still named "Mabel Charitable Trust" as beneficiary. The IRA provider's documents say the benefits are payable to the estate if there is no beneficiary named or the named beneficiary doesn't exist. Under Mabel's will, the estate pours over to her revocable trust, most of which is then placed into the Smith Family Charitable Foundation. We've told the IRA provider to just pay the IRA proceeds directly to the new foundation, but the IRA provider is telling us we have to get a court order to do that! Can you help us persuade the IRA provider that their position is ridiculous, wrong, and a violation of the American way? 

Answer: Unfortunately, I think the IRA provider is kind of, well, right. If you didn't bother to update your client's beneficiary designation form when she redid her estate plan, you are the one who created this problem, not the IRA provider. 

A state court might be willing to reform the beneficiary designation to reflect the client's intent, but you have to go through the steps of convincing the court that this was her intent. Or you can open a probate and get a court order that way, if the IRA provider is willing to pay to the estate (assuming you convince them the named beneficiary doesn't exist). The probate court might be willing to direct the IRA provider to pay directly to the charitable foundation to save steps and paperwork. Or you can run the account or the proceeds of the account through the estate and through the trust on their way to the charitable foundation, taking great care along the way to avoid getting taxable income from the IRA trapped in the estate or noncharitable trust. I just do not see a "shortcut" here to make the problem go away. 

Moral for planners: You will be very, very unhappy if your client dies and you then discover that the beneficiary designation form is missing, out of date, or just plain wrong. To live a happy life, you must draft (or at least review) the beneficiary designation forms for all your clients' significant retirement plans as part of the estate planning process. Every time the plan is reviewed (which should be at least every two or three years), review all those forms again, because clients tend to move assets around and because plan administrators sometimes lose forms. The beneficiary designation form is not a trivial thing--it often controls more assets than the will!

What do practitioners say about Natalie Choate's book
Life and Death Planning for Retirement Benefits?"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 http://www.ataxplan.com.



Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is a 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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