Your retirement account may be one of the most valuable things you own. Many people consider naming their children as the beneficiaries of these accounts because they think it is a way of easily transferring their wealth if something happens to them. However, there are some factors that make this type of transfer more complicated than you may think, especially if the named beneficiary is your minor child.
Can a Minor Be Named Individually as a Retirement Account Beneficiary?
The answer is both simple and complex. Yes, you can name your minor child as the beneficiary of your retirement account or as the contingent beneficiary (or backup beneficiary) who would inherit if the named primary beneficiary dies before you pass away. However, if your child is a minor when you die and they inherit, a court has a couple of options for how to settle inheritance on a minor child. The first option is for the court to appoint either a guardian of the estate to handle any money distributed to the child from the account. This will take time and money, and the guardian the court chooses may not be the person you would have chosen. Another option for the court to create a trust to hold and manage the funds while your child is a minor. This also takes time and money, and often requires a corporate trustee to manage the funds held in trust for your minor child. You can avoid these outcomes by proactively naming a guardian for your minor child in your estate plan.
Retirement Beneficiaries and the SECURE Act
Under the Setting Every Community Up for Retirement Enhancement (SECURE) Act, most beneficiaries must receive the entire contents of a retirement account within ten years of the account owner’s death. However, minor children of an account owner fall into a special category of beneficiaries (called eligible designated beneficiaries or EDBs). Their mandatory ten-year payout period does not begin until they turn twenty-one. This means the beneficiary must receive an entire inherited retirement account by age thirty-one. In the meantime, however, they must take the required minimum distributions (RMDs), which will likely be held in a protected account overseen by their guardian or conservator, until they reach the age of majority in the state they live in (for Texans is eighteen).
The RMDs for these EDBs are based upon the child’s expected lifetime, and they must take them until the end of the calendar year that they turn thirty-one, at which time the retirement account must be fully distributed. It is important to note that the child will have to pay income taxes on any amounts distributed to them. This is usually favorable because the RMDs up until the year they turn thirty-one can be made in smaller amounts because of the long life expectancy of a minor and because they will likely be in a low tax bracket. However, the account must be emptied by the end of the calendar year in which the child turns thirty-one.
Depending upon the size of the account, this could mean that the child will receive a large amount of taxable income at a relatively young age. In addition to the potential tax liability, one of the disadvantages of naming a minor child as the beneficiary of your account is that when they reach the age of majority (which could be as young as eighteen in your state), they will gain complete control of the funds and could choose to pull everything out of the retirement account right away, regardless of whether they are mature enough to handle that responsibility.
Who Should You Name as the Beneficiary of Your Retirement Accounts?
While it is always best practice to name a guardian of your children, in case something should happen to you. Another option is to create a trust for your child and to name the trust as the beneficiary of your retirement account. This option can work for see-through trusts that meet certain criteria under the law and allow the applicable beneficiaries of the trust to be treated as the beneficiary of your retirement account. There are two types of see-through trusts you can consider: conduit trusts and accumulation trusts.
A conduit trust requires all RMDs made from the retirement account to the trust to be distributed to the child (or used for the child’s benefit) as soon as the trust receives it. The trust will provide asset protection and tax deferral for the funds that remain in the actual retirement account. In addition, the terms of the trust can ensure that once the child reaches the age of majority, they will not be able to simply withdraw the entire balance remaining in the retirement account all at once. The trustee may also have discretion to withdraw funds from the retirement account in addition to the RMDs, which would then be distributed to or for the benefit of the child, However, the decisions about additional withdrawals will be made by the trustee, rather than the child. Although the remaining balance must still be fully distributed to the child by the end of the calendar year in which the child turns thirty-one, until that time, the conduit trust will provide asset protection, tax deferral, and additional time for your child to mature and learn how to handle the money responsibly before receiving a potentially large sum of money.
An accumulation trust, unlike a conduit trust, provides the trustee with the discretion to decide whether to pay out the RMDs to the child (or for the child’s benefit) from the retirement account or to retain the funds in the trust. As a result, the full amount of the funds distributed from the retirement account to the trust can stay in the trust and can potentially be protected from claims made by outside creditors. An accumulation trust will enable you to ensure that the funds are not distributed to your child sooner than necessary or desired and that the child does not gain access to the entire amount in your retirement account as young as eighteen. However, the funds must still be fully withdrawn from the retirement account by the end of the calendar year in which your child turns thirty-one. Any funds retained by the trust instead of distributed to your child will be taxed at the much higher tax rates applicable to trusts rather than the lower rate that is likely to be applicable to your child.
We Can Help
There are pros and cons for each option, and the one that is best for you and your child will depend on your unique circumstances and goals. We can help you think through whether asset protection, tax minimization, or another goal should be your priority. If you already have made your minor child a beneficiary of your retirement account or have set up a trust as the beneficiary of your retirement plan for the benefit of your children, it is important to review and update your beneficiary designations and your trust if needed. Some recent changes in the rules that govern these important accounts will have a big impact on when the funds must be distributed—and may necessitate a change in your plan. Please call us to schedule an appointment so we can help you think through the best plan for your retirement accounts, as well as any other estate planning concerns. Nielsen Law PLLC provides family focused estate planning in the Austin, Round Rock, Cedar Park, and the Central Texas area. For more information and to learn about our firm, please contact us. We look forward to hearing from you.