By Sean O’Connell, CPA/PFS, CGMA

High net worth Americans have accumulated more than half of their wealth in retirement accounts like 401(k)s and individual retirement accounts (IRAs). And while most account owners list their spouse as the primary beneficiary, the contingent beneficiary designations are equally important. Creating a retirement plan trust helps to ensure that children inherit the accounts’ full value.

Issues Listing Contingent Beneficiaries by Name

A spouse who is listed as the primary beneficiary of a 401(k) or IRA will have the most flexibility when inheriting account assets. He or she can:

  • Treat the account as their own
  • Roll the assets into their own retirement account(s)
  • Disclaim all or a portion of the account balance

Other beneficiaries generally do not have these options; however, disclaiming account assets is available to any beneficiary.

Most taxpayers name children as contingent beneficiaries.  But the account holder could be putting their accumulated wealth at risk. In situations ranging from divorce, serious illness or accident, bankruptcy, or others, retirement account assets could be claimed by a beneficiary’s former spouse, should they ever divorce; medical bills; car accident plaintiff’s claims; or bankruptcy. These are just some of the potential risks of naming a child as a contingent beneficiary.

Taxpayers can take steps to protect their retirement account assets from many unintended consequences and allow their children to inherit the full account value(s). There are two basic steps to accomplish this:

  1. Create a retirement plan trust, and
  2. Update the beneficiary designation for retirement account(s).

What is a Retirement Plan Trust?

Retirement plan trusts function as the beneficiary upon the taxpayer’s death. They’re ideal for high net worth taxpayers or individuals with a significant amount of assets in a 401(k) or IRA. All or some of the account assets can pass to the trust the same way that beneficiaries receive a portion or all of an account’s assets.

Also known as “see-through” or “conduit” trusts, retirement plan trusts act as a direct link between account assets and the trust beneficiary. These trusts require expert drafting to ensure accuracy and legal continuity. Required minimum distribution (RMD) rules still apply and would be calculated upon the account owner’s death.

When properly drafted, the retirement plan trust provides several benefits:

  • Assets can pass to the trust tax-free upon death, as they do to an individual.
  • Trusts can protect the inherited retirement accounts from creditors, predators, and lawsuits.
  • They can’t be named in a divorce, bankruptcy, or other litigation. In this way, the trust helps to keep a family’s assets in the family.
  • Each trust has a named trustee, and can also have co-trustees or backup trustees. This could help to protect against an heir potentially blowing through their entire inheritance.

Updating Beneficiaries with a Retirement Plan Trust

Once created, the new retirement plan trust will be listed as the beneficiary, as follows:

  • For unmarried account owners – the primary beneficiary.
  • For married account owners – the contingent beneficiary. (The spouse would typically remain the primary beneficiary).

Taxpayers need to keep in mind that while the last will and testament is one of the most important estate planning tools, this document has no control over assets in retirement accounts. When determining where to transfer the balance of those accounts, all eyes will refer to their beneficiary designations.

When a retirement plan trust is named as a beneficiary, it can “inherit” the remaining value of retirement accounts and protect accumulated wealth for the next generation. And because updating retirement account beneficiaries is an often overlooked step, ensuring the proper trust is in place also provides peace of mind that account assets will be passed on to heirs as intended.

There are many considerations to think about when deciding how wealth should be passed down to the next generation. Different solutions may involve different tax impacts. For help evaluating your options, contact PBMares Partner Sean O’Connell, CPA/PFS, CGMA.