The Importance of Keeping Beneficiary Designations Updated
It can be difficult to incorporate retirement accounts, life insurance policies and other non-probate assets into a client’s larger estate planning goals because such assets fall outside the control of a will or trust. Working with clients to keep non-probate assets within the confines of a broader estate plan is extremely important to achieving a client’s estate planning objectives. Doing so requires regularly updating beneficiary designations.
Two U.S. Supreme Court cases and a recent IRS private letter ruling underscore this point. In PLR 201706004, the IRS was faced with a decedent whose IRA beneficiary designation named a trust that was never created. Two U.S. Supreme Court cases, Eglehoff v. Eglehoff, 532 U.S. 141 (2001) and Hillman v. Maretta, 569 U.S. ____, 133 S. Ct. 1943 (2013), set forth the consequences of failing to update beneficiary designations following a divorce.
In the private letter ruling, a decedent named a lifetime revocable trust as the beneficiary of his IRA. His Will made no mention of the trust. It left all of his assets to his surviving spouse. At his death, neither his spouse nor anyone else could find evidence the trust existed. A state court order deemed the surviving spouse the recipient of the IRA. The IRS agreed that the surviving spouse should receive the IRA but confirmed that she was not the named “designated beneficiary.” Failing to be named as a designated beneficiary often carries significant tax consequences. As a quick aside, there are several ways to receive an inherited IRA distribution:
1. You can take a lump sum distribution and pay the tax on the entire distribution. This has the potential to push the beneficiary into a higher tax bracket for the year of distribution.
2. If the decedent has not yet reached the required beginning date (generally 70 ½), the beneficiary can spread out distributions over five years to defer the tax liability over that period.
3. If the decedent has reached the required beginning date, the beneficiary can spread out distributions over the life of the decedent.
4. If you are a designated beneficiary (e.g., an individual or qualifying trust who is named on a beneficiary form with the IRA custodian), you can set up an Inherited IRA and take required annual distributions based on the beneficiary’s life expectancy. If your goal is to defer income tax, setting up an Inherited IRA is your best bet. The younger the beneficiary, the smaller the required annual distribution.
5. If the designated beneficiary is also the spouse of the decedent, the spouse may use a spousal rollover or treat the IRA as her own --- meaning she may defer distributions for years if she has not yet reached 70 ½.
Here, the decedent did not list his spouse on his IRA beneficiary designation. In effect, he listed no one. In the letter ruling, the IRS stated that the spouse could receive the IRA but since she was not a designated beneficiary, neither of the last two distribution options were available to her. Her best option was the five-year payout (the decedent had not yet reached 70 ½).
Failing to list any beneficiary on a retirement account carries significant tax consequences to the ultimate beneficiary or beneficiaries of that account (generally, the residuary beneficiaries under the decedent’s will or the intestate takers).
But mistakenly leaving an incorrect beneficiary listed as the designated beneficiary has its own consequences, as Eglehoff and Hillman indicate. In both cases, the decedents named their spouse as the designated beneficiary on a retirement account or life insurance policy. Both later divorced, and died before changing the beneficiary designation. Under the Uniform Probate Code (UPC), those gifts would have been revoked had they been made in a Will. UPC 2-804(h)(2) contains a “revocation on divorce” clause such that any gifts made to a divorced spouse are automatically revoked even if the Will or other provision is not updated. (C.R.S. 15-11-804 contains the equivalent Colorado statute on revocation upon divorce).
The UPC and the Colorado statute treat revocation on divorce as applicable to both probate and nonprobate gifts (i.e., the provision covers retirement accounts and life insurance policies) but the Supreme Court struck that provision down in both Eglehoff and Hillman. Essentially, the Court found that federal law (in this case, ERISA and FEGLIA, the “ERISA” of life insurance) preempted state law on the issue and neither ERISA nor FEGLIA contained a revocation on divorce clause.
What we’re left with is no enforceable law which revokes gifts to a divorced spouse for nonprobate assets governed by federal law. All the more reason to listen to your estate planner – keep your beneficiary designations updated and check them regularly to ensure they continue to comport with your intent.