IRA beneficiary designation mistakes
Advisers must distinguish between their ability to provide financial advice and the client’s need for legal counsel.
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With more clients expressing an interest in using trusts as individual retirement account beneficiaries, it is important for financial advisers to distinguish between their ability to provide financial advice and the client’s need to obtain legal counsel.
This issue is tricky, as IRA beneficiary designation forms serve both a financial and an estate-planning purpose. Because of the dual nature of the forms, an added layer of formality will help advisers and their clients avoid costly mistakes.
At first blush, adding a trust as an IRA beneficiary appears straightforward. Based on guidance from the Internal Revenue Service, trust beneficiaries may be treated as IRA designated beneficiaries if the trust meets certain requirements.
By looking through the trust to the individual beneficiaries, the trust is in a position to take advantage of the stretch IRA rules.
Generally, the age of the oldest beneficiary is used for purposes of determining the annual required minimum distribution.
The basic trust requirements are as follows:
(1) the trust must be valid under state law.
(2) the beneficiaries must be identifiable from the trust instrument.
(3) the trust must be irrevocable or become irrevocable upon the participant’s death.
(4) the relevant trust documents must be provided to the plan administrator in a timely manner.
(5) all beneficiaries must be individuals.
Although these five trust criteria look simple, assessing their status is a matter of law.
For instance, whether the trust is valid under state law is a legal question.
Whether it is irrevocable or may become irrevocable upon the death of the participant is a legal question as well.
Moreover, as with all legal questions, the devil is in the details.
For instance, determining whether the trust has any non-individual beneficiaries can be difficult.
It requires a thorough review of the trust language, and an understanding of the law governing primary and contingent beneficiaries.
A mistake in any of these criteria can cause the trust to fail to qualify as an individual beneficiary and accelerate potentially hundreds of thousands of dollars in income taxes.
Unfortunately, any mistakes that are made in the beneficiary designation process probably won’t surface for many years.
It is generally upon the death of the IRA owner that technical deficiencies come to light.
At that point, of course, it is generally too late to fix the problems.
Therefore, it is important to make it clear to clients that IRA beneficiary forms are estate-planning documents.
As such, the forms should be reviewed and completed under the direction of the client’s estate-planning attorney, particularly for any client who intends to use a trust as a beneficiary.
By including the attorney in the process, an adviser may find out that the attorney doesn’t think the client’s current trust is properly drafted to serve as a beneficiary. It’s also possible that the attorney may believe that using an alternative to the trust may be more appropriate.
In any event, it is important to get the legal issues in front of a legal professional.
Using a trust as a beneficiary also requires a certain amount of continuing compliance monitoring.
Laws and regulations are constantly changing. Changes to the legal requirements may affect provisions that are buried deep in the trust documents.
[More: What an adviser should do when a client names them as a beneficiary in their will]
Consequently, the client’s attorney is in the best position to advise the client about any future required modifications.
While there is temptation to rush the application process when securing a new client, establishing some formalities around naming IRA trust beneficiaries is good risk management.
For clients who want to add a trust, the best approach is to have the attorney complete the beneficiary designation form.
If that is not possible, then obtain written instructions from the attorney regarding the beneficiary designation and forward a signed copy of the form to the attorney for his or her records.
Trusts are becoming an important IRA-planning tool. While financial advisers can provide their clients with important guidance on the potential use of trust beneficiaries, the determination about whether a trust will achieve the client’s estate-planning objectives is a legal question.
Consequently, suggesting that the client’s attorney oversee the beneficiary designation process is the most appropriate course of action.
At the end of the day, this formality will often result in better planning and help avoid a costly mistake.
Charles J. Farrell, J.D., LL.M., is an investment adviser with Northstar Investment Advisors LLC in Denver.
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