Estate planning is challenging enough when there’s a blended family of two spouses who each have children from a prior relationship. The problem can be compounded when a spouse’s assets are top-heavy with retirement accounts. Not only can these assets trigger potentially large income tax liabilities but also certain laws can interfere with the parties accomplishing their objectives.
Let’s address three common situations and the steps that can, or must, be taken for the parties to achieve their stated objectives with their retirement assets. The situations are:
- Dividing the assets.“We want my children to get my retirement assets and my spouse’s children to get my spouse’s retirement assets.”
- Avoiding disinheritance of children.“How can I use my retirement assets to benefit my current spouse without disinheriting my children from my prior marriage/relationship?”
- Ex-spouse listed as beneficiary. “I’ve been married twice and divorced twice. I named my ex-spouse from my last marriage as the beneficiary of my retirement accounts, but I haven’t changed the beneficiary form since the divorce. Is that a problem for my children from my first marriage? I want them to get the assets.”
Dividing the Assets
It’s a common preference for clients who are entering into a second marriage to have their retirement assets inherited by their own children. The easiest way to accomplish this is for each individual to name their own children (or a see-through trust1 for their children) as the beneficiaries of their retirement accounts. The parties might stipulate this arrangement in a prenuptial agreement (prenup).
The problem is that there’s a federal law that may prevent their desired objectives from taking place. If retirement assets are held in an employer plan, such as a profit sharing plan, an employee stock ownership plan or an Internal Revenue Code Section 401(k) plan (401(k) plan), then federal law requires that a participant’s benefits must be “payable in full, on the death of the participant, to the participant’s surviving spouse.”2 (Emphasis added.)For example, if the children from an earlier marriage are named as the beneficiaries of a 401(k) plan, then generally those assets must instead be distributed to the surviving spouse. This is the case even when there’s a binding prenup that provides that the children from a prior marriage are entitled to the assets.3
How can these assets be distributed to children from a prior marriage if that’s what the parties intended? The first step is to determine whether the assets are held in a retirement account that’s subject to this law. The law applies to employer plans described in IRC Section 401(a). Notably, it doesn’t apply to assets held in an individual retirement account because IRAs are governed by IRC Section 408 rather than Section 401. Even when assets held in an IRA were rolled over from the deceased spouse’s 401(k) plan (that is, from a plan in which the surviving spouse would have been entitled to all of the assets on the spouse’s death), courts have permitted the named beneficiaries to receive these IRA assets instead of the surviving spouse.4
In addition, the law doesn’t apply to “government plans” or “church plans,”5 though some of those plans may opt to include such a provision in the plan document. With Section 403(b) plans, the provision appears to apply to balances that were funded with employer contributions under the Employee Retirement Income Security Act (ERISA 403(b) plans6) but might not apply to balances funded entirely with voluntary employee elections (non-ERISA 403(b) plans). Again, some administrators of Section 403(b) plans may insist on a spousal consent even when it might not be required as a matter of law.
If the retirement assets are in an employer plan that’s subject to this surviving spouse rule, then the second step is to obtain a written waiver from the surviving spouse. This will permit the plan to distribute the assets to the individuals or trusts that were named as beneficiaries on the plan documents. The spouse must acknowledge the effect of the waiver, and the document must be witnessed by a notary public or by a plan representative.7 If the participant, while married, wants to later change the beneficiaries, then another waiver will be required.8
A written prenup won’t qualify as a waiver. The document must be executed while the couple is married.9 One way to address this requirement in a prenup is to insert a provision that the parties agree to execute any documents after they’re married to implement the terms of the prenup. Then, after the parties are married, the waiver and any other relevant documents can be executed.
If a waiver wasn’t executed before the death of the participant, then the surviving spouse can execute a document after death that has the combined effect of both a waiver and a qualified disclaimer for estate and gift tax purposes. Such a waiver/disclaimer also has the effect of shifting the taxable income from the surviving spouse to the beneficiaries who’ll actually receive the retirement plan distributions.10 Although the general rule is that a disclaimer won’t be valid if an individual accepted any benefits from the disclaimed property,11 the Internal Revenue Service permits a beneficiary who received a distribution in the year of death to still disclaim all or part of an inherited retirement account.12
Finally, if the surviving spouse takes the assets in violation of a prenup or other agreement, the children might have a cause of action in state court for breach of contract. All of the ERISA provisions will have been satisfied after the assets have been fully distributed from the retirement plan. At least one state court has been receptive to a claim filed by an estate after the retirement assets were transferred to an ex-spouse in violation of an agreement executed by that ex-spouse.13
Avoiding Disinheritance of Children
Leaving qualified retirement assets outright to the surviving spouse is always the best tax strategy, as long as it fits within the client’s objectives. On many occasions, a client is extremely reticent to leave retirement assets outright to a spouse, for a variety of reasons, including the existence of a subsequent marriage, asset protection concerns, spendthrift concerns or disability concerns. For non-retirement assets, a common solution is a lifetime trust for the surviving spouse, with the remainder interest designated for other beneficiaries. If asset protection, spendthrift protection or some other disability protection is the objective motivating the client to consider a trust for the spouse, make sure that the client understands the real cost in naming a trust versus naming the spouse outright. A lifetime trust for a surviving spouse has the following consequences:
The surviving spouse can’t roll over the IRA, and therefore, distributions from the IRA must begin in the calendar year after the first spouse’s death instead of being deferred until the surviving spouse attains the age of 72. Therefore, if the surviving spouse is younger than 72, a tremendous tax deferral opportunity will be lost.
Minimum distributions during the spouse’s life will be based either on a single life expectancy table or over a 10-year period, depending on how the remainder interest is structured. If the benefits were left outright to the surviving spouse, then once the spouse begins receiving distributions from the rolled over IRA, the surviving spouse uses the Uniform Lifetime Table, which is based on the joint life expectancy of the surviving spouse and a hypothetical new spouse who’s 10 years younger. Thus, the lifetime trust beneficiary designation forces larger annual distributions and less income tax deferral.
If the lifetime trust is intended to qualify for the estate tax marital deduction, then we have even more issues. One of the major requirements for a marital trust (either a general power of appointment trust or a qualified terminal interest property (QTIP) trust) is that the surviving spouse be entitled to all income of the trust, at least annually.14
Revenue Ruling 2006-2615 considered whether the “all income” requirement was satisfied when such a trust was named as the beneficiary of an IRA. This ruling concluded that the trust may not meet the “all income” requirement if: (1) the trust language didn’t require the trustee to distribute to the spouse the greater of: (a) all the income of the IRA (considered as if the IRA were a separate trust), or (b) the annual required minimum distribution (RMD) under IRC Sections 408(a)(6); and (2) the governing law included Sections 409(c) and (d) of the 1997 version of the Uniform Principal and Income Act.16 If the intention is for the QTIP to qualify for the estate tax marital deduction, then the trust must receive the greater of the RMD amount or the amount of income earned by the IRA. If the income earned by the IRA exceeds the RMD amount, then greater amounts must be distributed from the IRA and less deferral is achieved.
As an alternative to the QTIP trust technique in second marriage situations, you can try to persuade clients to instead leave a fractional amount to the surviving spouse and fractional amounts to the children of the first marriage. A common or somewhat offsetting distribution scheme for non-retirement assets can be contemporaneously made by the client.
Another alternative is to leave the total retirement asset amounts to the surviving spouse, and ”compensate” the children of the first marriage with non-retirement assets. However, this approach requires more constant maintenance, as the relative values of these two categories of assets fluctuate with time or other variables.
Yet another alternative is to establish an irrevocable life insurance trust to own life insurance on the life of the qualified plan owner. The proceeds of such life insurance can then be designated to benefit the children of the prior marriage, while designating the surviving spouse as the outright beneficiary of the qualified retirement plan. Of course, the qualified plan participant must be insurable at a reasonable cost, and such policy premiums and costs of implementing and maintaining the irrevocable trust must be within reason, in the participant’s judgment.
Ex-Spouse Listed as Beneficiary
Whether the ex-spouse or the children will receive the assets can vary depending on whether the assets are held by an employer plan or by an IRA and how the applicable state law applies to trusts that continue to name an ex-spouse as a trust beneficiary.
If the assets are held by an employer plan, then the retirement assets will be distributed to the beneficiary named at the time of death (that is, the ex-spouse). This is the case even when a state law explicitly provides that an ex-spouse isn’t entitled to such assets. The U.S. Supreme Court reached this conclusion in the landmark case of Egelhoff v. Egelhoff17because ERISA preempts any state law that would otherwise apply.18 Employers that operate in all 50 states are entitled under ERISA to rely on the beneficiary designation and won’t be required to learn potentially conflicting laws in each of the 50 states.19 The Supreme Court also concluded that an ERISA plan should distribute assets to an ex-spouse named as the beneficiary even when that ex-spouse agreed to relinquish all claims to the assets as part of the divorce separation agreement.20
By comparison, this ERISA provision doesn’t apply to IRAs.21 Consequently, the law of the applicable state will determine the outcome. An IRA is either a domestic trust or a custodial account.22 What does the applicable state law provide when an ex-spouse is still named as the beneficiary of a trust at the time of an individual’s death? The outcomes may vary state by state. Some states have laws that only disinherit ex-spouses who are named in wills, whereas other states have statutes that attempt to extend this policy to nonprobate transfers, such as trusts and transfer-on-death provisions.
Obviously, the best advice is to have divorced individuals change the beneficiaries of their retirement accounts, trusts, life insurance policies and transfer-on-death accounts if they don’t want their ex-spouses to receive these assets. But do the children have a state court remedy after an ex-spouse receives retirement assets in violation of a separation agreement, divorce decree or prenup? At least one state court has been receptive to such a claim.23
Endnotes
1. The 2022 proposed regulations on required minimum distributions (RMDs)specifically use the term “see through trust.” When such a trust is named as the beneficiary of a retirement account, then “certain beneficiaries of the trust ... (and not the trust itself) are treated as having been designated as beneficiaries of the employee under the plan.” Proposed Regulations Section 1.401(a)(9)-4(f)(1)(i).
2. Internal Revenue Code Section 401(a)(11)(B)(iii)(I).
3. Treasury Regulations Section 1.401(a)-20, Q&A-28; Hurwitz v. Sher, 982 F.2d 778 (2d Cir. 1992).
4. Charles Schwab & Co. v. Debickero, 593 F.3d 916 (9th Cir. 2010).
5. The last sentence of Section 401(a) states: “Paragraphs (11), (12), (13), (14), (15), (19), and (20) shall apply only in the case of a plan to which section 411 (relating to minimum vesting standards) applies without regard to subsection (e)(2) of such section.” IRC Section 411(e)(2) relates to government and church plans.
6. The Employee Retirement Income Security Act (ERISA), Section 205.
7. IRC Section 417(a)(2)(A).
8. Ibid.
9. Supra note 3.
10. General Counsel Memorandum 39858 (Sept. 9, 1991).
11. IRC Section 2518(b)(4).
12. Revenue Ruling 2005-36. This can be very helpful if the beneficiary received the decedent’s RMD in the year of death before having time to do any serious estate planning.
13. Martinez-Olson v. Estate of Olson, 328 So.3d 14 (3d D.C.A. Fla. 2021).
14. IRC Section 2056 and Treas. Regs. Sections 20.2056(b)-5(f)(1) and 20.2056(b)-7(d)(2).
15. Rev. Rul. 2006-26.
16. A new revenue ruling replacing Rev. Rul. 2006-26 and concluding that the “all income” requirement is satisfied by marital trusts governed by the laws of a state adopting the Uniform Principal and Income Act (UPIA) 2008 Section 409 is needed. The American College of Trust and Estate Counsel has formally requested that the Internal Revenue Service issue a revenue ruling concluding that marital trusts governed by UPIA 2008 that hold IRAs or defined contribution plan benefits satisfy the “all income” requirement. (The Uniform Law Commission further amended the UPIA in the summer of 2018, specifically in Sections 102(19(C), 203(e)(1) and 309(b), placing limits on a trustee’s power to adjust between income and principal, so as to avoid marital deduction qualification issues.)
17. Egelhoff v. Egelhoff, 532 U.S. 141 (March 21, 2001). David Egelhoff’s children from a previous marriage relied on a Washington statute that provided that the designation of a spouse as the beneficiary of a nonprobate asset (defined to include an employee benefit plan) was automatically revoked on divorce.
18. 29 U.S.C. Section 1144(a) provides that ERISA “shall supersede any and all State laws insofar as they may now or hereafter relate to any employee benefit plan” covered by ERISA.
19. “The state statute also has a prohibited connection with ERISA plans because it interferes with nationally uniform plan administration.” Egelhoff, supra note 17. Thus, with one exception, employers can rely on the name of the beneficiary at the time of the decedent’s death and can ignore any conflicting state law. The one exception (when someone other than the named beneficiary receives the assets) is if the participant dies while married. In that case, ERISA provides that the surviving spouse is entitled to the assets, as described earlier in this article. Section 401(a)(11)(B)(iii)(I).
20. Kennedy v. Plan Administrator for DuPont Savings and Investment Plan, 129 S. Ct. 865 (2009).
21. Individual retirement accounts are governed by IRC Section 408 rather than by Section 401.
22. Sections 408(a) (“a trust created or organized in the United States”) and 408(h) (“custodial accounts”).
23. “The Estate asserts that ERISA does not preempt post-distribution suits against named beneficiaries to enforce a contractual waiver of plan proceeds. We agree and approve the growing body of case law supporting the Estate’s position that it can sue to recover the proceeds after they are distributed by the ERISA plan administrator pursuant to the plan documents.” Martinez-Olson, supra note 13, at p. 21.