Setting Contingent Beneficiaries Of Retirement Plans When You Have Young Children

***This post describes some of the complexities in choosing the contingent beneficiary of a retirement plan for parents with young children.  It is intended to help explore options and set up conversations to be had with a qualified attorney.  It is NOT intended to be legal advice.  Please consult a knowledgeable estate planning attorney before making any decisions around your estate plan***

Note: Throughout this post, I refer to the Will as the document that sets the rules for distribution of probate assets and the establishment of any Trusts.  Rather than repeatedly mentioning a Living Trust, which could contain this same language in a Living Trust and Pourover Will setup, I will exclusively refer to the Will.  The complexities and decision points apply to both situations.

When someone with a retirement account dies, that account passes to the decedent’s primary beneficiary as stated on the account.  If the primary beneficiary is already deceased, the account passes to the stated contingent beneficiary instead.  If no beneficiary is stated or no stated beneficiary is alive, then the account passes to the decedent’s estate and goes through probate, following the provisions of the decedent’s will or state intestacy laws if there is no will.

Most parents would want their assets to pass to their spouse if that spouse is alive.  Hence, naming the spouse as primary beneficiary is often an easy choice.  But what if the spouse is not alive?  Generally, the parent would want the assets to pass to the children.  If the children are all old / mature / educated enough to manage their own affairs, naming children outright as contingent beneficiary(ies) make sense.  Some issues arise when the children are not old / mature / educated enough to manage their own affairs.  This is the case I’ll discuss in this post.

The typical estate planning setup that I encounter for parents with young children is a Will for each spouse containing provisions for the establishment of a Trust for any assets left to the children at death of the second parent.  That Trust has formal rules set by the parents describing when the Trustee is allowed to use the funds for the child’s benefit (typically health, education, maintenance, and support), and when the principal remaining in the Trust is to be distributed outright to the child (typically in a lump sum or in stages at the attainment of certain ages or levels of education, or at a particular life event).  This works well for assets that pass through the estate, but retirement plan beneficiary settings supersede any provisions in a Will.

If a child is named as contingent beneficiary of a retirement plan, the rules in the Will that establish a Trust for the benefit of the child are bypassed and instead the child will own the retirement account outright, via a custodian either specified in the retirement plan beneficiary form, if applicable, or as appointed by a court.  In these cases, when the child reaches the Age of Majority (18 in most states), he/she will have 100% control of the assets in the account with no restrictions.  If parents were satisfied with this result, they wouldn’t have set up a Trust for the child in their Will that would prevent unrestricted access to assets until the child is old/mature/educated enough to handle the money.

So what are the other options here?  The parents could name their estate as the contingent beneficiary, or they could name the Trust that is created by their Wills as the contingent beneficiary.  Let’s examine each of these.

If they name their estate, the account will pass through probate and follow the terms of the Will.  If the Will is constructed properly, it will be able to pass a retirement account that is inherited by a child into the Trust that is created by the Will for that child.  That means preserving the structure that prevents unrestricted account access by the child until qualifications (as defined by the Trust) are met to receive that access.  However, leaving a retirement account to an estate can have negative tax consequences.  That retirement account will need to be distributed out of tax-advantaged status over a maximum of five years.  If the account is sizeable, that could mean distributing large amounts of pre-tax income each year, or worse, into the last year if distributions aren’t taken every year.  Since tax rates are progressive, and pre-tax income becomes taxable when distributed, that could mean paying higher than necessary income taxes, thereby foregoing an unnecessary portion of the inheritance to taxes.

If the parents name the Trust that is created for the child in their Will, then again, the structure that prevents unrestricted access by the child at the Age of Majority is preserved.  Additionally, if that Trust qualifies as a “look-through” trust, then the retirement account won’t have to be distributed until 10 years after the child reaches the Age of Majority.  This gives much more time to spread out the distributions of pre-tax income so that they’re not all lumped into one or a few years, causing a high tax-rate to apply.  Note that prior to the passes of the SECURE Act in December of 2019, the distributions could have been spread (or more commonly “stretched”) over the lifetime of the child by taking a small Required Minimum Distribution (“RMD”) each year after the death of the account owner.  The SECURE Act eliminated this “stretch” for most beneficiaries, replacing it in the case of a child inheriting a retirement account by eliminating the RMD requirement, but adding a requirement that the account be distributed within 10 years of the child reaching the Age of Majority. 

So naming the Trust that is created by the Will preserves the restricted access that most parents desire and gives a better tax treatment than naming the estate would.  This seems like the best option for most people, but it too comes with some complexities.  First, as noted above, the Trust created by the Will must be a “look-through” trust.  That means it must 1) be valid in your state of residence, 2) it must only leave assets to a living person (no charities or complex provisions where the ultimate beneficiary of the Trust cannot be ascertained), 3) the Trust must be irrevocable at the death of the retirement account owner (so the terms can’t be changed) and 4) the retirement account custodian must have a copy of the Trust on file.  While not overly difficult, this means the attorney that creates the Trust language must be aware of your intention to name the Trust as beneficiary of a retirement account while still preserving tax-advantaged status for as long as possible. 

Another complexity is in how the Trustee of the Trust will ultimately distribute the retirement account into the Trust and then to the child.  Prior to the SECURE Act, two types of trusts could be used.  One, known commonly as a “conduit trust” would receive RMDs each year from the retirement account and distribute them to the child as income.  This had the advantages of avoiding trust tax rates, which are higher than individual rates, by passing each year’s income to the child, who is typically in a low income tax bracket.  It also meant that only a small amount of the account would be distributed each year, thereby applying the lowest marginal tax rates possible to the inherited amounts.  Remember though that the SECURE Act eliminated RMDs for inherited accounts.  Without RMDs, there is nothing to distribute each year under the conduit trust structure which would leave only one big distribution to the child in the 10th year after reaching the Age of Majority!  If you have a conduit trust structure that doesn’t provide the Trustee with the ability to distribute principal from the retirement account, you have a real mess on your hands.  Those with estate plans already in place should consult with their attorney to make sure this won’t impact them in the post-SECURE Act world. Those building their estate plans now clearly want to avoid a conduit trust setup.  The other type of trust that was used pre-SECURE was known as the “discretionary trust”.  This type of trust would receive RMDs each year but hold them in the Trust rather than distributing them to the child by default.  If the child needed money from the Trust for valid reasons as defined by the Trust, then the Trustee would have discretion to distribute it.  A discretionary trust can still work post-SECURE Act, but the Trustee needs to balance taking distributions from the retirement account to minimize a large bill later with the needs of the child in any given year and the high trust tax rates for any retirement account distributions that are retained in the trust.

A final complexity in naming the Trust that is created by the Will as contingent beneficiary of a retirement account is the skill/experience required of both the attorney that sets up the estate plan and the trustee that is left as responsible for making the distribution decisions.  From my experience, not every estate planning attorney knows how to best create a look-through trust in a will that is capable of preserving tax-advantaged status while maintaining a structure that will prevent the money from reaching the child in unrestricted form too early in life.  Additionally, parents often choose a relative or family friend as the Trustee of the Trust.  That person may not have the experience or understanding of all these complexities to minimize taxes each year and over the life of the Trust.  While an outside advisor can surely be hired to assist, the Trustee may not even realize the complications and the inefficiencies that will result from poor optimization.

Options, pros & cons

Now, you may note that all of this only comes into play if both parents die while the child is still young.  That’s true.  The complexities of a child inheriting a retirement account are only an issue at the death of the second spouse if there are still young/inexperienced children at that time.  That makes the ultimate event where the child actually inherits the account before they’re capable of dealing with it properly a low probability event.  Unfortunately, parents are building assets in retirement plans while their children are young and the possibility of early death still exists, regardless of that low probability.  This means the creation of estate planning documents and naming of beneficiaries in a thoughtful, coordinated way is necessary for all parents that don’t want to risk giving children unrestricted access to large sums of money the day they turn 18 or losing substantial amounts of the child’s inheritance to income taxes.  In other words, you won’t know if your estate planning documents and beneficiary selections are important until exactly that time when it’s too late for you to do anything about them.  Therefore, it makes sense to set them up in a way that will handle this worst case, rather than pretending that the worst case can’t happen to you.

One final note…  I’m often asked if it’s ok to create estate planning documents via an online service that uses templates and fills in the blanks with your answers to interview questions.  If the service is capable of guiding you through the complexities described above such that you can thoughtfully answer the relevant interview questions, and capable of creating documents that address these complexities, then have at it.  Or, if you understand these complexities enough to choose simplifications that will work for you such that the service’s offering can handle your requirements, then again, go for it.  Technology is amazing, but I’m skeptical of this approach.  In my opinion, there is little/no point to an estate plan that doesn’t work and leaves a mess to be sorted out by your heirs.  In some cases a bad estate plan can even be worse than no estate plan at all.  If you’re wealthy enough to have (or assume you will have in the future) sizable amounts of money in retirement plans, then it’s probably worth spending some money to get your estate plan in order with the help of an actual attorney.     

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