Double Check your Beneficiary Designations on all of your Retirement Accounts
August 30, 2016
In July of this year the IRS released Private Letter Ruling (PLR) 2016-28004 which dealt harshly with a mistake made by the custodian of an Individual Retirement Account (IRA) in naming their client’s (now deceased) estate as beneficiary of his IRA’s causing loss of the stretch- the benefit of the IRA to be paid out over the lifetime of a beneficiary.
The case involved a client who originally named several trusts as beneficiary of his IRA's. The client's financial planner who handled the initial transaction later switched firms. The client decided to transfer his IRA assets to the financial planner's new firm. The planner had the client fill out a standard beneficiary designation form mistakenly naming the client's estate as the beneficiary at the time the client moved to the new firm. The client signed the form without reading it assuming that his trusts were still the beneficiary of his IRA's.
The problem surfaced when the client died and the beneficiaries could not stretch out IRA distributions over their lifetime because the client's estate was named as beneficiary. Only an individual beneficiary or a trust that has special conduit or look-through provisions are afforded the opportunity to stretch out distributions in avoidance of the five (5) year payout rule. The five (5) year payout rule provides that non-individual (i.e. non-human) beneficiaries of retirement accounts must receive their share within a five year period of the death of the retirement account's owner. So for example, if an IRA owner names his estate as the beneficiary of an IRA valued at $500,000, then at the time of his death the beneficiaries of the deceased IRA owner's estate would have to take their share within the five (5) year period. The inability of a beneficiary to stretch out the distribution of proceeds from the IRA beyond the five (5) year period can lead to significant loss of growth of retirement account assets held in a tax deferred environment as well as exposure of such assets to potential creditors and claimants of the beneficiaries who prematurely receive them. In most states, as with North Carolina, assets held in retirement accounts enjoy special protection from claimants under state law. So in most cases, it is optimal to keep assets in retirement accounts for as long as possible.
Upon realizing that a mistake had been made causing loss of the stretch-out, the client's beneficiaries went to state court to reform the beneficiary designation forms naming the decedent IRA owner's estate as beneficiary. The state court agreed that the IRA owner did not intend to name his estate as beneficiary of his IRA's upon his death and that a mistake had been made. The court reformed the beneficiary designation form to show the IRA owner's trusts as the designated beneficiaries of his IRA's and made the designation retroactive to the date the decedent owner moved his IRA's to the new firm. However,
regardless of the court's reformation of the beneficiary designation form, the IRS refused to acknowledge the reformation for TAX purposes. According to the PLR the deceased client's estate continues to be the beneficiary for tax purposes causing loss of the stretch (and loss of potential growth as well as exposure to potential creditors and claimants). The reformation by the state court was not considered relevant for tax purposes.
The PLR should serve as a warning to ensure that beneficiary designations are properly made and consistent with your estate plan especially when retirement accounts (401k's, IRA's, etc) are transferred from one financial firm to another. In addition, if you have named a living trust as the beneficiary of your IRA’s you need to make sure your trust contains the special conduit provisions to allow beneficiaries of your retirement accounts to stretch out distributions over their lifetime. The PERNA LAW FIRM stands ready to help. Call today for a free consultation to review your beneficiary designations and ensure that they are consistent with your overall estate plan.