Beneficiary Designations as Part of an Estate Plan

     Recently I sat down with the client who came to see me on the advice of his children. This client had more than a passing familiarity with estate plan documents and came to our meeting prepared to reject most of my advice for updating his estate plan. The client's primary argument against needing even a simple Will was his use of beneficiary designations naming each of his children as the beneficiary for various assets. As I reviewed the situation, the client's beneficiary designations were mostly correct and he had done a good job of naming primary and contingent beneficiaries for his major assets. We still decided to draft a simple Will to help organize the process of probate, but that got me thinking about the effectiveness of beneficiary designations in general.

     In most cases, beneficiary designations are the simplest manner of passing an asset at death without the need for that asset to pass through the Probate Court. Life insurance beneficiary designations, retirement plan beneficiary designations, and even "TOD" (transfer on death) designations used by banks circumvent the probate process. While this is a simple method, frequently requiring only the completion of a form, it may not be the most effective method. Due to the contractual nature of beneficiary designations, the institution holding the assets pays them directly to the named beneficiary. Unfortunately, there are scenarios where this will not happen smoothly, and the courts will become involved anyway.

     For example if your named beneficiary is incapacitated, a court-appointed Guardian or conservator will be required in order to take control of the assets. The same is also likely true if the designated beneficiary is a minor, because all financial institutions seek to avoid the potential liability of paying out to a minor, or even to a parent of the minor for the child's benefit.

Even if the beneficiary receives the assets directly from the financial institution there can still be many unintended consequences. The beneficiary of a tax-deferred retirement account may decide to cash out the asset immediately instead of taking advantage of the tax benefits of a long-term payout.

     Other designated beneficiaries may have creditor problems that consume their entire inheritance.. A spouse in divorce can reach assets received. For beneficiaries receiving federal government benefits, the sudden influx of money will likely cause the beneficiary to lose benefit eligibility.

     Frequently when we discuss beneficiary designations with our clients we recommend naming their Living Trust as the beneficiary so that the protections of the Trust extends to all of the client assets, and the Trust can act as a clearinghouse for the assets. This allows the Trust's "spendthrift" and "incapacitated beneficiary" clauses to protect the beneficiaries whose personal or financial situations might be otherwise disadvantaged by a sudden influx of money.

      This is not to say that beneficiary designations naming individuals are an ineffective form of estate planning. However, anyone relying on beneficiary designations to achieve their planning goals should take the time to review those designations and confirm they have not missed any major assets and that all contingencies are covered by those designations. As with the client who inspired me to consider this topic in the first place, it is also always advisable to execute at least a simple Will to organize the probate process and ensure that any assets passing through the Probate Court go go to those beneficiaries the client prefers.

Matt Ferrara

Planning for the Terminally Ill Client, Part II

     As we discussed last time, when a client becomes seriously ill or is diagnosed with a terminal illness it is obviously a trying time, but a complete review of their estate planning documents is important. We previously discussed the Durable Power of Attorney and the Patient Advocate Designation, but a client's Trust and funding documents also require review.
     The client may have neglected to update their Living Trust despite changes in the client's financial situation and family situation. Their estate planning documents require revisions because of these changes in order to avoid adverse consequences. Items to consider include:

1. The value of assets in the Trust may have increased dramatically since the last time the Trust was reviewed. Distribution terms for spouse and children may need to change because of the increase in assets. 
2. If the spouse or the other family members have been identified as being spendthrifts, the terms of distribution may need significant revisions. Rather than allowing for automatic distributions within the spouse's total discretion, an "ascertainable standard" as defined by the IRS, may be more appropriate so that the Trustee has the ability to pay or withhold principal and/or income for the spouse's benefit. 
3. The children who are beneficiaries may have creditor issues, unhappy marriages or destructive dependencies, which may require restrictions on distributions to protect them from themselves. 
4. If the client has remarried since the last time the Living Trust was reviewed and modified, provisions may be needed to protect the children of the prior marriage. While it is normal for the client to want to protect the current spouse as long as the spouse is alive, the trust should provide for the eventual distribution of principal to the client's children. Otherwise, the second spouse may be able to distribute assets to her family, disinheriting the client's children. 
5. Because of the increased size of the estate, or because of changing charitable inclinations, a client may want to make charitable contributions at death. 
6. The client may no longer be comfortable with those persons designated as Trustees and Successor Trustees to administer the trust assets for the benefit of spouse and children. 
7. A client may want to revise the trust to protect the current spouse demanding children or a second spouse. 

     In addition to carefully reviewing the trust distribution provisions, a client should review the ownership of assets to confirm that all of the assets have been transferred to the Living Trust or beneficiary designations revised where appropriate, in order to avoid probate upon the client the death. If not, these transfers should be made soon as possible.
     Once these changes are handled, the client can be comfortable that if the worst happens, loved ones will be protected.

Alan Ferrara

Other IRA Issues with Estate Planning

On Tuesday, I discussed funding retirement benefits to a Living Trust and some of the issues that may come about because of the funding. In response to that post I received a few comments and questions on related issues and thought it a good idea to expand on the topic in today's post.

The first comment talked about the opportunity of using a direct IRA beneficiary trust as well, to mandate a "stretch-out" of distributions and protect non-spouse beneficiaries from creditor claims. We discussed the IRA Trust in our post on November 20, 2012, but it is worthwhile discussing it again.  

The “IRA Trust”, is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement other benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of their inherited benefits over their lifetime. Using the IRA Trust allows the client to design a special trust specifically for the IRA assets and perhaps even for different beneficiaries then for the majority of the estate under the client's Living Trust. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of this spending in mismanagement of money. Additionally, if an IRA trust provides for more than one beneficiary, if the IRA beneficiary designation form specifies the percentage of the account that will go to a specific sub trust for each of the beneficiaries, each beneficiary can then use their own life expectancy in calculating the RMDs for a particular year.
     A second comment asked how one meets the "see-through" trust requirements when one of the trust beneficiaries is a charity or other non-individual beneficiary. When a client names non-individual trust beneficiaries, those beneficiaries can be "removed" as a beneficiary for the purposes of determining the “see through” status of the trust. To “remove” the non-individual beneficiary the trustee must either make a distribution of the amount allocated to that beneficiary or arrange for the beneficiary to disclaim their interest. The deadline for this “removal” is September 30 of the calendar year following the calendar year of the account owner's death (the "Beneficiary Finalization Date"). If this is accomplished, the regulations exempt the non-individual trust beneficiaries for purposes of determining individual beneficiaries.
One might ask why anyone would disclaim his or her interest in a Living Trust. In some cases an older beneficiary will disclaim their interest in the IRA assets of the trust, because it will allow the younger beneficiaries (perhaps grandchildren in their 20s) to extend the IRA distributions over the lifetime of the oldest life expectancy of that group. This is important because unless you eliminate the elder beneficiary, all of the beneficiaries must use the oldest beneficiary's life expectancy in calculating the RMDs. Alternatively, a charitable beneficiary may disclaim an interest in IRA assets in exchange for a larger immediate gift that it can invest or put to use immediately.

On a final note, if there are sufficient assets in addition to the IRA to protect loved ones, and the client is charitably inclined, client may want to consider designating one or more charities as the beneficiary of the IRA. This will satisfy their charitable inclinations will save significant income taxes because the IRA will not be subject to income tax when paid to the charity. This can save a large amount of tax, especially where the estate is taxable for estate tax purposes and then the IRA is taxed for income tax purposes as it is distributed to individual beneficiaries. Naming a charity as the IRA beneficiary excludes it from taxation for federal estate tax purposes and income tax purposes.

Again, it is important that a client discusses their desires with experience counsel prior to designating beneficiaries in order to protection of beneficiaries and minimize taxation of the account.

Funding Retirement Benefits to a Living Trust

As part of the trust funding process, I normally suggest that clients change the beneficiary designation of their IRAs and retirement benefits. Most of the time, I suggest that their spouse be the primary beneficiary and the Living Trust be the secondary or contingent beneficiary, because spouses receive better distribution rights under federal law with respect to retirement benefits. If the spouse predeceases the account owner, or if it makes sense for other reasons for the spouse to disclaim the retirement benefits, the benefits then fall to the Living Trust where, in all probability, the spouse remains the primary beneficiary and if the spouse has already died, the beneficiaries of the Living Trust become beneficiaries of the retirement benefit.

After contacting their financial professional, clients will often call me concerned because their financial professional warned them against designating the Living Trust as beneficiary of the retirement benefits because their children will not be able to "stretch out" the IRA over their lifetime, and the entire benefit will be taxable immediately. While this advice may be well meaning, it is often incorrect.

The Internal Revenue Code (the "Code") and Regulations provide that a "designated beneficiary" can use the provisions which allow a beneficiary to take minimum required distributions (MRD's) over their life expectancy. Normally, only an individual can be a "designated beneficiary", therefore a Living Trust ordinarily is not a "designated beneficiary" because it is not an individual. There is an exception to that rule and, if the trust document meets certain requirements, then the Living Trust is considered a "see-through" trust and the regulations treat the beneficiaries of the Living Trust as designated beneficiaries of the decedent's retirement account. To achieve “see through” status, the Living Trust must meet the following requirements:

1. The trust is a valid trust under state law, or would be but for the fact that there is no corpus.
2. The trust is irrevocable or will, by its terms, become irrevocable upon the death of the account owner.
3. The beneficiaries of the trust with respect to the trust's interest in the employee's benefit are identifiable from the trust instrument
4. Required documentation has been given to the Plan Administrator. The Plan Administrator must receive a copy of the trust instrument and a list of all beneficiaries of the trust with a description of the conditions on their entitlement.

If the trust meets all the requirements then the Living Trust beneficiaries are deemed “designated beneficiaries", entitled to receive their MRDs over their life expectancy.

The next issue when a Living Trust is the beneficiary of IRA benefits usually arises at the account owner's death. At that point, clients want to know whether the beneficiaries can split the “inherited IRA” into separate IRAs and make their own decisions about how distributions are made. Generally, "inherited IRAs" received by beneficiaries other than a surviving spouse, cannot be rolled over to their own IRA, but the account can be split into separate IRAs for the trust beneficiaries using the designation "John Doe IRA for the benefit of Beneficiary A", etc. Beneficiaries can then decide the manner in which they want their IRA distributed. One beneficiary may take a lump sum distribution, pay the tax and invest or spend the rest. Alternatively, a beneficiary can decide to take MRD's over their designated life expectancy, deferring income tax until future distributions are made.

Along with the question of splitting an “inherited IRA”, is the question of whether the MRD's are based on each beneficiary's own life expectancy or on the life expectancy of the oldest beneficiary.

Regulations §1.401(a) (9)-8, A-2 provides the general rule that if the account owner's benefit is divided into separate accounts no later than the last day of the year following the calendar year of death, distributions subsequent to the division are treated as separate accounts and each beneficiary of each separate account can use his/her own life expectancy in determining minimum required distributions each year. However, this rule does not apply to beneficiaries receiving a "separate share" through a trust that was the beneficiary of an IRA. Therefore, even if beneficiaries split the IRA into separate accounts for each beneficiary, all the beneficiaries must use the life expectancy of the oldest beneficiary of the Living Trust in determining their MRD's.

The law and regulations governing “inherited IRAs” is both vast and complex, before designating beneficiaries of retirement benefits, you should consult with a professional expert in that area. At the death of the account owner, it is important to seek additional advice as to the best way to retitle the accounts or distribute the assets. These experts should take the time to understand your unique situation and provide you with an understanding of the consequences of decisions, not just provide you with the forms needed to make changes.

Estate Planning and the Single Client

     Much of the writing we have done at Plainly Legal focuses on planning for the married couple with children. While this particular demographic has many reasons to ensure their estate planning is complete and up-to-date, they are certainly not the only ones who should feel that need. Estate planning is just as important for the unmarried individual as it is for their married counterparts. 

    As we have previously written, a primary purpose of estate planning is to distribute assets to the individuals and charities of your choice. For a married couple lacking an estate plan, the intestacy statutes deliver the vast majority of assets to a surviving spouse. Coupled with a natural tendency for married couples to own property and bank accounts jointly, the statutes insure the surviving spouse retains control of their deceased loved one’s assets. For an unmarried individual there is no surviving spouse, nor is property normally held with survivorship rights. Most, if not all of the assets of an unmarried individual are owned solely by that individual. The Michigan intestacy statute, which controls if there is no Will or Trust, distributes assets through the family tree starting with parents, then to siblings, then nieces and nephews, then aunts and uncles, and so forth. Depending on family size and closeness of living relatives, assets may be distributed to relatives who have not been seen in years or spread among a large number of people. 

     Even when an individual wants assets to go to their extended family, they frequently would prefer to know that those assets will be used for certain purposes. For example, parents may have sufficient assets of their own and a person may want their assets split among their siblings to ensure that their nieces and nephews can pay for college. Intestate succession can deliver those assets to the siblings outright (presuming that parents are deceased), but offers no guarantee that the siblings will use the assets to pay for their children's education. However, by establishing a trust, the individual has the ability to make those assets available to their nieces and nephews to help pay for their education without worrying that the money will be spent before those nieces and nephews reach college age. 

    Alternately, a person may wish to look out for their parent’s needs in the future. An outright distribution to the parent can potentially affect the parent's ability to qualify for other government benefits. By establishing a trust that makes discretionary distributions to the parent, it is possible to provide a parent with a higher standard of living without having those assets used before government benefits are available. An additional benefit of this method is the ability of the person to decide what other beneficiaries, or charity may inherit any assets that remain at the parent's death. 

     Speaking of charities, taking the time to prepare an estate plan ensures that the single individual’s assets passing to charities, friends, and other loved ones that he or she sees fit to provide for at their death. Those who rely on the intestacy statutes to distribute their assets do not have this option, as the statutes never provide for distribution outside of the bloodline. 

    An unmarried person should not forget to make appropriate beneficiary designations for any retirement benefits, including IRAs, or life insurance they may own individually, or through benefits provided by their employer. If a beneficiary designation is not made, the benefit must go through probate and is controlled by the intestacy statute. With appropriate beneficiary designations, a person can designate specifically who should receive the benefits. 

      In discussing distributions at death, it is also important to consider is the disposition of personal property. Personal property may have significant value, such as collectibles or artwork or may just have sentimental value because they have been passed down through the family for generations. In the absence of any estate planning this property passes along with all other assets through the Probate Court. Under the statute, family members, who may not be aware of their loved one’s personal life or inclinations, control the destiny of their personal items. Through estate planning, items of value, both sentimental and monetary, go to those people the person knows will appreciate them most. 

       As with everyone else who creates an estate plan, the documents that function during lifetime are as important to a single individual as they are to the married couple. Documents such as HIPAA Authorizations and Patient Advocate Designations ensure that doctors and hospitals know who the person desires to make medical decisions on their behalf should they become incapacitated. Furthermore, a Durable Power Of Attorney ensures that someone is authorized to make legal decisions on the person's behalf. In the vast majority of married couples the husband and wife name each other in these roles, but for a single individual the decision is less obvious but equally important. 

     Many of the single individuals I speak with are reluctant to put together a plan, frequently because they either are worried about offending a family member either through their gifting or by who they named to make decisions and act as trustees. Others find such decisions difficult because they are not close to family, and contemplating what happens after they die makes them uncomfortable. When speaking to people with such concerns I find it helpful to remind them that while through events or circumstance they may not be close to their genetic family, they have surrounded themselves with friends and loved ones who fulfill those roles in their lives. By failing to plan for the inevitable, they ultimately affect those people who they love the most, even if they are not genetic family. Close friends are no less affected by the death in the family member and it is important not to add to their burden. 

     Obviously, there are reasons for everyone to engage in estate planning. For an unmarried individual, control over distributions and choosing people to make decisions on your behalf that you are close to, as opposed to family, are high on the list. It is also important to remember that by having an estate plan including a trust, it is possible to avoid the time and expense of the probate process. Finally by engaging in the estate planning process individuals begin the process of a lifetime of planning, something that single individuals frequently delay because there is less imperative to plan when the only concern is their own well-being.

The Effects of Divorce on Estate Planning

     Divorce is frequently a difficult and painful experience for the parties involved. By the time the proceedings are complete, most people want to go their separate ways and interact with their former spouse as little as possible. Unfortunately, as with other major life events, divorce is also a time where it is important to review and update an existing estate plan.

Under Michigan law, divorce has a substantial effect on existing estate plan documents, including:

• automatic revocation of any potential disposition of property made by a divorced individual to his or her former spouse as a beneficiary under a Will or Trust;
• automatic revocation of provisions conferring powers of appointment on the divorced individual’s former spouse so that the former spouse can no longer appoint beneficiaries under a Will or Trust; and
• revocation of any nominations of the divorced individual’s former spouse to serve in a fiduciary or representative capacity rendering the former spouse unable to act as Personal Representative or Trustee even though named in the document.

     Additionally, divorce severs interests of a former spouse in property held at the time of divorce as joint tenants with rights of survivorship, and it is important to retitle real estate following a divorce. While all of these changes result in a change in the distribution of assets via estate plan documents, they do not negate the documents themselves, therefore the documents continue to function and successor beneficiaries, including minors, may become the primary beneficiaries because of the divorce. If there are no successor beneficiaries, then the Intestacy Statute dictates distribution of those assets.

       Presuming that successor beneficiaries are named, the change in beneficiary is important because in many documents there is a presumption that should something happen to the Grantor their now former spouse will receive such distributions and the terms of the trust did not adequately provide for direct distribution to minor children. Further, even when there is adequate provisions for maintain assets in trust for minors, it is important to ensure that the trustee named to administer that trust is a person the Grantor believes will look out for the best interests of any children and ensure funds are available for their long-term care. It is worth mentioning that a decree of divorce may contain provisions requiring the inclusion of certain provisions in an estate plan, including the purchase of life insurance to cover alimony or child support payments should something happen to the Grantor. Failure to comply with such requirements can have adverse consequences.

     While a review of the terms of the Trust, the beneficiaries, and the successor trustees is important, it is just as it is important to ensure those individuals who are designated to make decisions upon incapacity are also the people the Grantor now wants to make decisions on their behalf. Many people execute Patient Advocate Designations and Durable Powers of Attorney naming their spouses as the sole designee to make decisions on their behalf. Following a divorce those documents are revoked and the grantor is left without a designate to make medical decisions. Even if those documents name other successor designee, it is important to ensure that those individuals are still the best people to be making decisions should the Grantor become incapacitated. Frequently successor designee's are close friends of the couple, who may not continue to be actively involved in their separate lives following a divorce.

      As a side note, it is important to remember that in addition to revoking all the above interests held by former spouses, divorce also revokes interests held by former spouse’s relatives. Thus if after a divorce an individual wishes to continue to leave assets to a relative of the former spouse or name their former spouse’s relatives as a designee, it is necessary to execute new documents reaffirming that desire. While this may seem like an unlikely scenario, is important to remember how many people meet their spouse through a friendship with siblings, grow close to extended family during the course of a marriage, or feel that a former spouse’s sibling or parent is still a good trustee for minor children.

      Also related to updating estate plan documents, is the importance of updating beneficiary designations of assets that transfer outside of the probate process. This includes such assets as insurance policy proceeds and retirement benefits. Updating beneficiary designations are important because these beneficiary designations are a contractual agreement between parties, and divorce does not negate such designations. It is possible for a former spouse to receive large amounts of assets that the deceased certainly would rather have distributed to the beneficiaries of their newly updated estate plan.

      With all of the changes following the dissolution of the marriage, the updating of an estate plan can easily get lost in the shuffle. However due to the substantial impact that a divorce has upon an estate plan, it is important to take the time to review documents for necessary changes. When contemplating making changes be sure to consult an attorney to ensure that changes are made properly.