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Do Not Name Your Minor Children as Beneficiaries of Your Retirement Plan

Posted on: July 14th, 2015
Maryland Estate Planning for Minor ChildrenNaming Minor Children as Beneficiaries?

We recently received a question about naming minor children as beneficiaries of a retirement account.  The individual recently was divorced in Maryland and wanted to replace her former spouse with her minor children as the beneficiary of her retirement plan. Our response was first, to congratulate her for thinking about her assets and her estate plan during this time of stress and emotion with the divorce and while continuing to parent her young children.

Second, we summarized the options with respect to retirement plans and minor children. Below is a summary of our response to her.

(1) Minor children cannot own property or assets. Thus, if a retirement account is left to minor children directly, even if those children have a guardian, a court will need to be informed and will require that the guardian file reports annually indicating if and how the assets were spent on the children. You may know this as a conservatorship or guardian of the property.

(2) Once the child turns 18, the assets belong to the child. If your children are like most 18-year-olds, the assets will be gone in a matter of months. If these retirement accounts are traditional accounts, there will be a huge tax bill to pay the following April. Imagine leaving a $100k retirement account to your child and at 18, they take it in a lump sum and spend it. The following April, they will owe $40k in federal income taxes, not to mention state taxes.

(3) You can fill out the Beneficiary Designation Form to set up Inherited IRAs for the children. These would be much better--if the plan administrator is willing to do it. The problem with this, again, is that the child can elect to take a lump sum when he or she turns 18. Also, due to a recent Supreme Court decision, the assets in an Inherited IRA are subject to creditor claims in some situations, so it is possible that your child's creditors may force the child to liquidate the entire retirement account and the creditor may take the assets.

(4) You can name your estate as the beneficiary. This is one of the worst choices because of the taxes that will be due on the lump sum distribution. 

HOWEVER, ALL IS NOT LOST

Here is the solution that we recommend to our clients and nearly all of them adopt it:

(5) You can set up a Living Trust or a Stand-Alone Retirement Trust and name the Trust as the beneficiary. The Trust then "owns" the assets upon your death and the Trust specifies how and when the children receive their inheritance. Usually they receive it over time at specific ages or specific milestones, such as college education, marriage, first house, etc. No Court involvement. No cashing-out at age 18. No lump sum distribution taxes to pay. Asset protection of the funds, from creditors and predators.

The Stand-Alone Retirement Trust can be designed as (1) a Conduit Trust, where the Required Minimum Distributions (RMDs) are withdrawn every year, but they are based on the children's life expectancy, which "stretches" the benefits further out over the years; or (2) an Accumulation Trust, where the assets stay in the Trust until the Trustee decides to distribute them to the beneficiaries. The latter has greater asset protection from the children's creditors but the former is sanctioned by the IRS. The Stand-Alone Retirement Trust must be drafted carefully to comply with all IRS rules in order to work. But when it works, it is produces an amazing result that saves taxes and protects your child's assets. 

As you can see, there are many technical factors to consider when dealing with retirement plans. Considering that retirement plans make up a huge part of estates these days, it is prudent to be careful with these assets and to plan properly now. Otherwise, you may leave a very expensive mess to your beneficiaries. It is important to think about this and act on it while you have many good options for planning.

This summary is not absolute and there are many technical details that accompany each of the items and options listed above. Anyone with a retirement plan should visit an estate planning attorney with substantial experience with retirement plans and tax consequences to ensure that it is passed on to beneficiaries and not diluted by taxes or confiscated by creditors.
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