Bad News, Good News

Retirement plan expert Natalie Choate answers reader questions about an intestate estate and how a lump sum decision would affect a SOSEPP.

 Natalie Choate  10/12/2012

Every day I answer questions for my readers and seminar attendees. Sometimes I have good news (when the answer is "there is no problem!") and sometimes not (as in the following case).

Question #1: Bad News: We are involved in a tragic situation of a young father's death. One of the many sticky problems involves the decedent's retirement benefits. "Father" (in his mid-40s when he died in a car crash) had a 401(k) plan at work and an IRA. He wanted to leave these benefits and his other assets in trust for his three children who are all minors. His attorney had drafted the trust as well as the necessary beneficiary designation forms, will, and other estate planning documents. "Father" had all these documents for review, but despite frequent reminders and urging from his attorney, his accountant, and his financial planner, he had never signed them when he died. So he died intestate. The IRAs have no beneficiary (default beneficiary is the estate) and the 401(k) plan's beneficiary designation form still names the decedent's ex-wife from whom he had been divorced for over three years. Is there a way to get the retirement benefits into an "inherited IRA" for the children? Can the estate disclaim the benefits in some way that would cause them to pass to the children?

Answer: The short answer is no.

The designation of the ex-wife as beneficiary is still valid. Even if applicable state law would automatically revoke a testamentary disposition in favor of an ex-spouse (that's what happens in many states), neither state law nor any private agreement between the divorcing spouses would be binding on the plan administrator of an "ERISA" plan (such as a 401(k) plan). So unless there was actually a "qualified domestic relations order" (QDRO) that was served on the plan, the ex-wife will receive the 401(k) plan benefits. If the decedent and his ex-wife had agreed as part of their divorce that she would not get those benefits, his executor can bring some kind of lawsuit to enforce that agreement against the ex-wife, unless the ex-wife is willing to cooperate and voluntarily waive her claim to the benefits.

Regarding the IRA benefits that are payable to the estate, those will be subject to the "five-year rule," meaning that all benefits must be distributed out of the IRAs within five years after the decedent's death. An estate is not a "designated beneficiary" so the life expectancy payout option is not available for benefits payable to an estate. In my opinion, the estate can transfer the inherited IRA, intact, to the children, but that will not extend the payout period beyond five years. The IRS has ruled that an estate cannot "disclaim" retirement benefits payable to it.

Of course it will probably be necessary to probate the estate in order to have someone (the executor) who is recognized as being legally entitled to the benefits.

If the decedent had taken care of his estate plan, probate might have been totally avoided, the ex-wife could have been omitted as a beneficiary, and all of the retirement benefits could have been safely transferred to an inherited IRA payable to a trust for his children, over the life expectancy of the oldest child. But that is not to be. Instead, between probate expenses, accelerated income taxes, and the claims of the ex-wife, this father's minor children will have much less money available for their support and education than they otherwise would have had.

Death sometimes comes a little earlier than expected. Are all your clients' estate plans up to date? How about your own estate plan?

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. She is a regular writer for Morningstar. The views expressed are the author’s.

Tax Friendly States for Retirees

Federal taxes are the same wherever you choose to retire; however, state and local taxes add up depending on the state you pick to spend your retirement years. Taxes may apply to your retirement/pension income, purchases, real estate and social security benefits.
Taxes on individual and pension income differ from state to state. Seven states in the U.S. (Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming) currently do not tax individual income. On the other hand, California, District of Columbia, Hawaii, Iowa, Maine, New Jersey, New York, Oregon, and Vermont tax retirement income at a rate of 8% or higher. Pennsylvania and Mississippi exempt pension income completely, while states like Michigan and Maine exempt only a portion of pension income. If you estimate receiving considerable income in retirement, state income taxes could play a significant role in what you get to keep.
In addition to state taxes on retirement and pension income, retirees also need to look at sales tax charged on items they purchase. Sales tax varies from state to state with some states charging sales tax as high as 7%, while others adopt a “no sales tax” policy. Alaska, Delaware, Montana, New Hampshire, and Oregon have no state sales tax, while California has the highest sales tax rate of 8.25%. Retirees who rely only on a fixed source of income in retirement should also carefully consider property taxes and estate taxes when estimating their tax liabilities.

Source: 2011 CCH Whole Ball of Tax. The opinions herein are those of Morningstar, Inc. and should not be viewed as providing investment, tax, or legal advice. The information provided is as of October 2011. Please consult with your financial professional regarding such services.