It is critical that you name the correct beneficiary for your tax-deferred retirement accounts. Deferring taxes allows your retirement account balance to grow, decreases the income taxes you have to pay, and helps your account’s “life” stretch out as far as possible. After you pass away, the new beneficiary’s life expectancy will determine the amount of the required minimum distributions (RMD’s). As you can guess, the younger the beneficiary, the better because it lowers the amount of the RMD’s. This means lower taxes and a the retirement account will last longer.
Naming an Individual
Unfortunately, naming an individual as a beneficiary is not a perfect situation. For example, if your beneficiary is a minor, the distributions will not go to the minor, but the minor’s guardian. If you name an older beneficiary, he or she may just cash out the account or take more than the RMD amount. This increases income tax and obviously cuts into the life of the account. Once your beneficiary receive the distribution, that money is now vulnerable to the beneficiary’s creditors, bad spending habits, and family members that you did not intend to have access. If your beneficiary ever became unable to take care of themselves, the court may need to step in or your beneficiary may not qualify for income-tested government aid.
Naming a Stand-Alone Retirement Trust
There is a better alternative: a stand-alone retirement trust. A stand-alone retirement trust gives you more control over your accounts, as well as more protection. A stand-alone retirement trust is separate from your basic revocable trust; this is necessary because the IRS has certain requirements for trusts of this kind, and having it separate makes it easier to fulfill those requirements.
How it works is that your stand-alone retirement trust will receive the required minimum distributions in place of your beneficiary. The trust will then either pay the distributions directly to your beneficiaries (acting as a “conduit trust”) or the trust can hold the distributions to accumulate them and then pay your beneficiaries according to your trust provisions (acting as an “accumulation trust”)
Naming a trust prevents the issues mentioned above (minor beneficiary and incapacity) from happening. The minor is not the beneficiary, so the court will not get involved, and the trust can never become incapacitated. An accumulation trust will give your trustee discretion on how to use the account distributions to take care of your trust beneficiaries, especially if they receive government aid.
Also, naming your trust as beneficiary and using it as an accumulation trust disallows the possibility of any individual cashing out your retirement account or taking out more than the required minimum distribution. An accumulation trust allows for greater protection from creditors because a conduit trust often pays directly to the beneficiary (who is subject to personal debts).
A last benefit is that your trust can name successor beneficiaries. You get to control who gets your retirement account distributions if your initial beneficiary passes away and there is still an account balance.