Knowledge Regarding Annuities and Secondary IRA Distribution Woefully Inadequate
An officer of a company which provides information and other services to IRA holders had a surprising answer when asked what question he encounters most frequently. Even more startling, this inquiry was asked not only by IRA holders themselves, but also by practitioners representing IRA owners. Here is that question:
"If a beneficiary designated by the IRA owner dies prior to the distribution of the entire IRA to that beneficiary, who is entitled to the balance of the IRA?"
This number one question was so startling because it is obvious! What does the document provide? For practitioners who routinely draft wills and trusts, it would be exceedingly rare to prepare a document which would not clearly identify the beneficiaries at any given time. Oddly, however, in regards to IRAs, the question continues to arise.
The purpose of this article is to discuss the fundamental concepts and provisions that should be used in naming beneficiaries for IRAs to avoid uncertainty about who is entitled to what from IRAs. Call it "IRA Beneficiary Designation 101".
To the author, there are three basic issues involved in naming the beneficiaries of an IRA, as follows:
- Identifying the beneficiary(ies) who is (are) entitled to receive the balance of the IRA at the participants death (the "primary beneficiary").
- Identifying the contingent beneficiary(ies) who is(are) entitled to receive the balance (if any) in the IRA; (a) at the death of the primary beneficiary, or (b) at the death of a contingent beneficiary.
- The determination of the annual minimum required distribution to any beneficiary under Code Sec. 401(a)(9).
Issue (1) usually does not present a problem. The IRA owner identifies the beneficiary of the proceeds at the owner's death. However, what the IRA owner may not realize is that naming a primary beneficiary will, in accordance with the usual printed IRA form, give that primary beneficiary the right to take distributions of any part or all of the IRA during that beneficiary's lifetime. This is simply because most IRA forms give the beneficiary the same power to make distributions as the IRA owner had during his or her lifetime. The author believes, but admittedly can not know, that many IRA owners are not aware of that provision in the IRA which gives the beneficiary the right to take any part or all of the IRA. Of course, there are many instances where the IRA owner clearly wants to give the primary beneficiary, usually the surviving spouse, the right to take all of the IRA. In fact, there are many Private Letter Rulings which specifically deal with the issue of giving the surviving spouse the right to make a "spousal rollover".
The ability of a surviving spouse to make a spousal rollover may be appropriate where the children of the IRA owner are also the children of the surviving spouse. In a harmonious family relationship, this would not present a problem to most IRA owners and, therefore, the right of the surviving spouse to elect the spousal rollover would not seem to prejudice the children.
However, take the case of the IRA owner who has children from a prior marriage and is currently married to a spouse who has his or her own children. In this situation, it would be most usual for the IRA owner to want to have the balance of the IRA at the surviving spouse's death be payable to his or her own children, not to the stepchildren. Yet, the typical printed IRA beneficiary designation form may thwart this very normal desire on the part of the IRA owner. This situation arose in Bank One, Milwaukee, N.A. v. Fueger.2 The decedent, Emil, had two children from a previous marriage. He opened an IRA account with Bank One naming his current wife (who had three children) as the beneficiary and his two children as contingent beneficiaries for any remainder amount. Emil died in 1987 at age 73. The surviving wife, Gisele, "continued" to receive monthly payments of $750 from the IRA account. In 1993 – six years after Emil's death – Gisele withdrew the balance of $63,000 from the IRA and deposited that amount on the same day to establish an IRA in her own name. When Gisele opened up "her own" IRA, she named her own children as beneficiaries. When Gisele died a year later, the balance of the IRA was approximately $56,000.
What next happened was predictable. The decedent's children both claimed the proceeds. Emil's children argued that his will and a marital property agreement evidenced his intent for his children to receive the IRA balance. According to the opinion, the IRA "adoption agreement" signed by Emil "clearly permitted Gisele to treat the IRA as her own and name her own beneficiaries." Emil's will gave Gisele "all of the benefits from an individual retirement account adoption agreement." The opinion further stated that both the federal tax law and the adoption agreement "provide that a spouse beneficiary may treat a deceased spouse's IRA account as her own." The trial court held, and appeals court confirmed, that Gisele's children, not the decedent's children, were entitled to the balance of the IRA.
The opinion does not discuss the family relationship between Emil and his stepchildren. However, it would be quite an unusual situation for a parent to prefer stepchildren over his or her own children. Yet, this is precisely the result in Bank One.
The lesson of Bank One, whether the decision was or was not correct,3 is that IRA beneficiary forms must be clearly understood by the IRA owner. If the printed IRA beneficiary form does not comport with the owner's desires, then the form has to be changed.
An alternative, which the author has used, is for a contract to be entered into between the IRA owner and his or her beneficiary (spouse or otherwise) which will restrict either or both of them with respect to the distribution of the IRA proceeds. Such an agreement would be enforceable by reason of the law of contracts and would, by its terms, explicitly control the distribution notwithstanding the content of the IRA. Such an agreement may not be binding upon the IRA sponsor, but would, nonetheless, compel the beneficiary to comply with its terms. For example, in the Bank One case, there could have been a contract between Emil and Gisele that the proceeds of the IRA at her death would go only to Emil's children, not to her children, even if she did validly elect a spousal rollover. But if the surviving spouse, under the terms of the IRA, had the right to demand distribution of all of the IRA during his or her lifetime, then an agreement restricted to the distribution of the proceeds at death might be worthless for the intended purpose. What is needed is a contract which would also restrict the surviving spouse's right to withdraw to some ascertainable standard, even though the IRA, itself, does not have that restriction. The legal principles relating to an enforceable contract to make a will should be compelling authority for a contract controlling the disposition of IRA proceeds as between adverse claimants.
A recurring problem arises when (a) the IRA owner has executed a beneficiary designation which named his or her current spouse as the beneficiary, (b) there is a divorce, and (c) the IRA owner had not changed the pre-divorce beneficiary designation. Who is entitled to the proceeds? There has been extensive litigation involving this type of situation.
It is not the purpose of this article to examine that line of cases, but to suggest a drafting solution which could eliminate the problem of the participant who forgets to change the prior beneficiary designation.
This problem could be averted if the IRA beneficiary designation executed by the IRA owner contained a provision which explicitly stated that the then beneficiary designation either shall, or shall not, continue to be valid if the participant and the then spouse are divorced. This type of a provision, similar to a prenuptial agreement,6 may be distasteful to the parties; but, it would go a long way in eliminating extensive and expensive litigation when the participant fails to make a change in the IRA beneficiary designation following a divorce.
We had heard about annuities and were investigating them for our IRAs. We also heard bad things about pushy brokers over the years. So when we went to the ImmediateAnnuities.com site we were skeptical about calling them. But whenever we called their staff was really friendly. They answered all our questions and one of their reps even told us that at our ages there was no advantage to buying the annuity with our IRAs. These guys are really honest!
The author has also been told that one of the principal problems regarding the beneficiary designation arises when there is more than one primary beneficiary and one of the primary beneficiaries predeceases the other when there is still a balance in the IRA. The typical printed form of an IRA beneficiary designation that the author has seen provides that the balance at the IRA owner's death is distributable to the primary beneficiaries equally or entirely to the survivor. When Beneficiary "A" dies, is Beneficiary "B" entitled to the entire balance? Such a "survivor takes all" provision is probably just what the participant-decedent did not want in the common situation where the participant has, for example, named his two children as equal primary beneficiaries and both of his children have children. As estate planning practitioners well know, the usual provision calls for a "per stirpes" distribution, i.e., the children of the deceased beneficiary would take the parent's share, so that the survivor of the decedent's children would not be entitled to the entire amount. A per stirpes provision is in virtually all testamentary documents, where the participant wants the grandchildren to take the deceased child's share. Practitioners must provide for the same result in the IRA beneficiary designation when the IRA printed form, itself, does not so provide.
Issue (2) above, the author has been informed, is more troublesome than issue (1). What happens at the death of the contingent beneficiary? This issue apparently arises simply because the printed IRA beneficiary designation form usually does not provide for the disposition of the IRA balance upon the death of a contingent beneficiary. Let's take a very typical situation to illustrate the problem. The IRA owner named the surviving spouse, John, as the primary beneficiary; John has now died. The named contingent beneficiary was the participant's son, Harry, who died when the balance in the IRA was $100,000. Typically, and unfortunately, the beneficiary designation form provided with the IRA did not go beyond the naming of the one contingent beneficiary. Who is entitled to the $100,000 balance?
Let us add another common fact. In virtually all printed IRA forms, a beneficiary has the same right to withdraw any amount at any time, i.e., there is an inter vivos general power of appointment.8 However, these printed IRA forms typically do not give the contingent beneficiary a right to dispose of the balance at his or her death, i.e., there is no testamentary power of appointment. Does the existence of an inter vivos general power of appointment, by implication, create a testamentary power of appointment, so that the contingent beneficiary could name the beneficiary for the balance of the IRA?
These may be interesting questions, but questions which should never arise if the IRA beneficiary designation has been properly prepared. The beneficiary designation for the IRA must explicitly provide for the ultimate disposition of the decedent's entire IRA account to an identifiable beneficiary. This will normally not be a problem for the disposition of the decedent's other assets; it will be a rare will or trust which would not ultimately provide "who gets what and when." Why is it, then, the number one question regarding IRAs?
This question arises, in the author's opinion, principally because many of the printed IRA beneficiary designation forms do not provide enough space to spell out what is to happen under various contingencies, or because the forms do not provide for sequential contingent beneficiaries. Too many clients and practitioners slavishly follow the form, perhaps because the clients do not want to pay for the practitioner's time and effort in changing a "free" printed form.
There are two ways of curing this problem. The method preferred by the author is to insert the words "See Beneficiary Designation Attached" in the usual limited space provided naming beneficiaries on the printed beneficiary designation form provided by the IRA sponsor. That attached beneficiary designation would provide the same type of distribution planning as the client's other testamentary documents provide, such as per stirpes distributions, cross-remainders and special powers of appointment held by the beneficiaries, whatever the client wants.9A second method would be to name an existing trust as the beneficiary on the printed IRA beneficiary designation form. The issue involved in the use of an "outside" trust as the beneficiary of the IRA proceeds constitute a separate topic beyond the scope of this article. At the very least, a well-prepared trust will eliminate the question of "who gets what and when."
Issue (3) involves the mandatory maximum distribution period. Proper planning for IRA distributions necessarily involves two separate, but related, considerations, i.e., identifying the beneficiaries and obtaining the optimum distribution period for different beneficiaries. It is reasonable to assume that virtually all readers of this article are familiar with the basic minimum required distribution rules for IRAs in Prop Reg § 1.40(a)(9)-1 and -2. For the purposes of this article, it is only important to point out that there is nothing in Code Sec. 401(a)(9), or under the Proposed Regulations, which limits the persons or entities which can be named as beneficiaries. The named beneficiaries will only affect the distribution period; and there is a way for both identifying the client's desired beneficiaries and providing for the annual minimum required distribution period for each beneficiary or group of beneficiaries. The author recognizes that his concepts of "customizing" IRAs may not be suitable or practicable for all clients, particularly when modest amounts are involved. But at the very least, every client is entitled to an IRA beneficiary designation which will clearly identify "who gets what and when." The litigation in Bank One involved "only" $56,000. It is the responsibility of the practitioner to eliminate the "most asked" question about IRAs.
- See article on spousal rollovers by author, Pension & Benefits Week, 8/26/96.
- 201 Wis.2d 216,549 N.W.2d 742, 1996 Misc. App. LEXIS 358 (Ct. App. 1996).
- The opinion relies on Reg § 1.408-2(b)(7)(ii)(1980). Prop Reg § 1.408-8 Q&A-4(a) provides that the 1980 Regulation applies if the decedent died before January 1, 1984. However, both the 1980 Prop Reg § 1.408-8 Q&A-4(a) provide that the "election" of a surviving spouse to treat an IRA as her "own" will be considered to have been made if "any required amounts...have not been distributed within the time period applicable to the decedent under section 401(a)(9)(B)." (emphasis added) In Bank One, Gisele continued to receive the same $750 per month as Emil had been receiving. Accordingly, it seems to the author that Gisele did not make her election in accordance with the Regulations, because of the continuation of the distribution of the same amounts to her previously made to Emil. A six-year hiatus between Emil's death and Gisele's rollover to her "own" IRA seems to violate the Regulations.
- See, e.g., cases and discussion at IRA Pension and Benefits Experts at ¶ 51,407 and ¶ 114,181.5. The cases cited involve the issue of determining the proper beneficiary from retirement plans, IRAs, qualified domestic relations orders ("QDRO") and welfare benefit plans. See, also McCarty v. State Bank of Fredonia, 14 Kan. App.2d 552, 795 P.2d 940, 1990 Kan. App. LEXIS 516, (effect of IRA beneficiary designation); Shelstead v. Shelstead, 58 Cal. Rptr.2d 522, 1996 Cal. App. LEXIS 1083 (Ct. App.) review granted Feb. 26, 1997, 61 Cal. Rptr.2d 809, 932 P.2d 756 (Sup. Ct.) (QDRO issue).
- Of course, there can be a situation where the IRA owner might not want to change a pre-divorce beneficiary designation. See, National Automobile Associates Retirement v. Arbeitman, 89 F.3d 496 (8th Cir. 1996).
- There is no ERISA involvement, in any event, because IRAs are not subject to ERISA, except under rare circumstances. See Labor Reg § 2510.3-2(d).
- House Counsel for a large mutual fund company recently told the author that the company's "new" printed IRA beneficiary designation form will provide a "per stirpes" distribution option, among other things, designed to make the IRA more "user friendly" for estate planning purposes.
- A general power of appointment may not be desirable for tax purposes. See discussion of this issue in the author's prior article on customizing IRAs, Pension & Benefits week, 5/27/97.
- The author prefers customizing an IRA which goes beyond just identifying the beneficiaries. At the least, every beneficiary designation must deal with the normal estate planning provisions. See article cited in note 8.
- See author's article on the use of "separate accounts" in Pension & Benefits Week, 12/23/96.