“Joe”, a widower, recently passed away owning an IRA and life insurance policies that named his daughter as a primary beneficiary, with his daughter’s children (Joe’s grandchildren) as contingent beneficiaries. Unfortunately, Joe’s daughter predeceased him, so his grandchildren stepped into the role as primary beneficiary.
When the children’s father went to collect the IRA and life insurance benefits for his children, the financial firms said that they wouldn’t pay the benefits directly to the children. This is due to the fact that the children were minors, and they cannot legally sign for the money. The children’s father offered to sign on their behalf, as the legal guardian.
Not good enough under the law.
The financial firms are concerned that if the father were to collect the proceeds and were to use them for his personal benefit, then the grandchildren could later successfully sue the financial firm for recovery. Believe it or not, this concern is well founded in the law.
So how does a minor beneficiary collect the benefits from a life insurance policy, IRA, annuity or other similar financial instrument that names the minor as a beneficiary? The usual course of action is to file a legal guardianship with the court. The child’s parent can be named as the guardian over the property (in this case “property” refers to the insurance and IRA monies), and the court will oversee the distribution of the proceeds. The guardianship will last until the minor child becomes an adult.
Every year the guardian of the property will have to petition the court to spend the money on behalf of the minor beneficiary. The guardian will also have an obligation to file formal accountings with the court – detailing income, expenses and distributions.
Sounds time consuming and expensive doesn’t it? One can certainly see how a guardianship proceeding will serve to protect benefits that could be improperly consumed by a child’s parent or other guardian, so the law makes sense.
But isn’t there an easier way?
There is. The easiest way to avoid an expensive court administration over the minor beneficiary issue is much the same method used to avoid probate. I’m talking about the use of trusts.
Assume, for example, that Joe instead created a trust. Instead of naming his grandchildren as contingent beneficiaries to his IRA and life insurance policy, he names his trust. The trustee that he appoints in the trust following Joe’s death (could have been the grandchildren’s father – could be some other trusted friend, relative or even a bank or trust company) would have the legal authority to collect the insurance proceeds and IRA monies and would then distribute those monies to or for the benefit of the grandchildren pursuant to the trust provisions.
If Joe were to want those proceeds held until the grandchildren reached college, and to pay for the college education using those proceeds, Joe could specify this in the trust.
Because the trustee of the trust has a fiduciary responsibility under the law to the trust beneficiaries, the financial firms can make the payment to the trustee without fear of their own liability under the law. Instead, the legal liability transfers from the financial service firm to whomever is serving as trustee of the trust proceeds for the grandchildren.
When dealing with IRA accounts, the trust that serves as the beneficiary needs to be drafted with a careful eye towards preserving the tax deferred benefits. Often the trust needs to have special provisions concerning the beneficiary’s “required minimum distributions” (MRD).
You may be aware that owners of IRA accounts have MRDs upon attaining the age of 70½. What you may not know is that EVERY beneficiary of an IRA account (including Roth IRAs) also will have MRDs – even if the beneficiary is younger than 70½. So the trust needs to include the five requirements for a beneficiary to be considered “identifiable” under the tax laws, and therefore be entitled to preserve the tax free growth associated with the IRA account.
I won’t bore you with the five requirements here. If you would like to read them for yourself, look up Treasury Regulation s.1.401(a)(9)-4. Then tell me how long it took you to get cross-eyed!
Failure for any trust to meet those five requirements often results in the IRA income being wholly taxed in the year following the IRA owner’s death. This is often a very bad tax result.
So if you have named minors as beneficiaries or as contingent beneficiaries to life insurance, IRAs or annuities, you should consult with your estate planning attorney to ensure that all of these issues have been addressed.
©2010 Craig R. Hersch