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Financial planning is a hot topic. With a click of a mouse one can find the "keys to retirement safety" plastered online. Unfortunately many of those "keys" require employees to directly invest for retirement and assume more of the risks. No longer are traditional pensions the norm. Today is the age of the 401(k), Roth 401(k), 403(b), 412(i), the SIMPLE, the SEP, the IRA, and the Roth IRA, among others. Acronyms abound, causing various frustrations to young attorneys looking to draw up even the most basic of estate plans.
Young attorneys must learn to recognize varying investment vehicles, their positive and negative attributes, and their place in the estate. One of the most commonly known and used is the 401(k). Therefore this article aims to educate neophytes, as well as those initiated in the practice of estate planning, to better understand the 401(k) and beneficiary designation.
Understanding the 401(k)
Stemming from its namesake - section 401(k) of the Internal Revenue Code - the 401(k) is a qualified retirement plan initiated by employers or self-employed individuals. Plan participants choose to divert a portion of their salary to fund the plan ("elective deferral"). Yet automatic enrollment is possible and, with Legislature's encouragement, becoming more probable. Hence, clients may not know if they can participate in a 401(k) at work and should be asked.
Participation often begins during the first opt-in window after the one-year anniversary of a client's start date. Of course, that too may change in light of recent legislation, resulting in automatic enrollment on day one of work. Nevertheless, incentives to participate may exist. Employers sometimes match contributions up to a stated percentage of salary. Thus, assuming a 100% match up to 5% of the employee's salary, for every dollar contributed by the employee two dollars is invested.
Plan participants may contribute up to $15,000 in 2006. Beginning in 2007, contributions are indexed to inflation. When employers match, the contribution is the smallest of 100% of compensation or $44,000. In either case, employees over 50 may contribute more. Taxes on income and subsequent earnings are deferred until distribution results or is required. Generally, distribution cannot occur until retirement at age 59-1/2 or later, death, disability or severance of employment. When no alternative plan is established or continued or, if the 401(k) is part of a profit-sharing plan, the employee reaches 59-1/2 or suffers a "severe hardship" as defined by the IRS, distributions are permissible. Yet a distribution is required to occur no later than April 1 of the year following the year the individual reaches age 70-1/2. Often plan assets are without "cost basis," resulting in full taxation of the distribution as income in the year made according to type. Types of distributions include periodic (over a term of years or life) and non-periodic (lump sum). Lump sum distributions put cash in the client's hands, but also require immediate payment of taxes unless other options are available. Be mindful that early distributions may be subject to a penalty. However a properly executed 401(k) distribution is not a taxable event.
Brokerages or fund companies typically manage the 401(k) plan according to "custodial agreements." But many decisions, such as allocation of assets, come from the advice of individual financial professionals. Note, though, that recent federal legislation allows companies to provide in-house investment assistance. In-plan investments often consist of stocks, bonds and mutual funds. The range of investments, however, depends upon products offered.
Designating a Beneficiary
At inception, participants usually designate a beneficiary using a "beneficiary designation form." Forms typically require the name, relationship and date of birth of the beneficiaries. Designating individuals, estates, trusts and charities is permissible. And married participants designating someone other than their spouse will require spouse approval. However, each designation comes with separate issues, discussed below. Additionally, designations set forth in a will or trust are usually ineffective. Investment companies require original signatures and often signature guarantees from a financial institution (i.e., bank or brokerage); notarization may not be acceptable.
A client who "never" received a beneficiary designation form should contact her investment representative for assistance. Beneficiary designation forms are often available online. However, execution in the presence of a professional prior to submission is highly recommended to ensure proper execution.
Debunk the Default Terms
Certain default rules and definitions exist in each plan. General rules place the spouse first, children second and the estate third. Still, each participant should research her plan's hierarchy before relying upon defaults. An uninformed decision could wreak havoc upon the estate and estate plan.
When relying on default provisions, clients and attorneys must understand both the legal and practical effects. For example, the definition of "spouse" affects plan participants differently. Someone in a same-sex relationship (or marriage) may not benefit from a default definition, unless it specifically encompasses her set of circumstances. Likewise, a perceived husband in a "common law marriage" might not receive his wife's assets if the default definition does not consider him a spouse. In either event, plan assets could pass from the deceased owner to someone other than the "intended" beneficiary. Thus, clients and attorneys must understand default provisions before using them.
Multiple Beneficiaries and Allocations
Active (as opposed to passive or default) designation of beneficiaries requires disposition of 100% of the assets. Allotment in excess of 100% often results in the payment of proceeds in proportion to the proposed allocations. For example, when two primary beneficiaries are named and each is supposed to receive 100% of the assets, each ultimately receives 50%. Also, when two or more primary beneficiaries are named and one predeceases the plan owner, all assets should pass to the survivor beneficiary. Participants often do not know, or understand, this possibility. Therefore, clients looking for relief from the contractual standards should consider the use of estate-planning instruments.
In addition, failure to name contingent beneficiaries results in distribution pursuant to default provisions. Without designations, assets are paid to the deceased participant's estate unless otherwise determined by law. Allocations up to 100% are required. Also, the death of one of the two or more contingent beneficiaries leaves the survivor receiving all assets.
Alternative Designations: Estates and Trusts
To name an estate as a beneficiary, enter "Estate of John Smith" in the form. That designation precludes distribution under contract - the "custodial agreement." The participant's will or state law then controls distribution. Assets also become subject to probate or administration. Hence, clients with 401(k) assets should have a will in place, understand intestate distribution, or preferably both when making this decision.
If a will exists, the estate receives a lump-sum distribution of assets. This taxable event will leave the estate with net proceeds for distribution. General, specific and residual bequests, and even testamentary trusts may then be satisfied. Or eliminating taxes and debts associated with other estate assets is possible. Nevertheless, creditors may reach 401(k) assets under this circumstance, which may not have otherwise been possible. The tax advantages of naming individuals as direct beneficiaries will also be lost.
Without a will, or if a will is invalidated, the domicile's state law controls. That could result in asset distribution to unintended beneficiaries. Spouses generally take first, unless a spouse and children exist. If only children survive they should get everything. And the saga continues according to statute. At the same time, creditors may once again reach 401(k) assets and tax advantages disappear. Thus, clients participating in 401(k) plans must make informed decisions when designating their estate as beneficiary.
Participants with a trust, of any kind, can designate it as the beneficiary by inserting the trust name in the form. Designating a trust allows the plan participant to: (1) avoid probate or administration delays and expenses; (2) possibly enjoy creditor protection of assets; and (3) further the trust's stated purpose using additional funds. Depending on the terms of the trust a lump sum distribution may be required, causing a taxable event. Each situation differs. A trust holding net, lump sum proceeds will have flexibility in management and investment. Alternatively, a trust that is eligible to continue the plan or roll it over may defer taxable gains, albeit while investing in the respective plan's products.
Handling the Intake
Prior to your session, ask clients to bring copies of current 401(k) statements. That provides you with: (1) the present value of 401(k) assets; (2) the name of their managing institution; (3) the name of the investment representative, if any; and (4) respective contact information. Although highly confidential, and not always divulged without hesitation, the statements should provide you with the best information available. Statements also help you realize that the client's "401(k)" is really an annuity, IRA or other investment vehicle, and possibly subject to different rules.
Clients should also contact their plan manager prior to your intake session and determine the current primary and alternate beneficiary of record. The proper contact is usually found in the upper right or left portion of the 401(k) statement. Likewise, clients need to determine the percentage of assets allotted to each beneficiary. Ideally, a client without that information should provide it before the estate plan is finalized.
Counsel the Client
Take time to review the effect of beneficiary designations with your clients. Inform them of the positives and negatives of defaults, specific designations or using a combination of both. Let them know that estates ultimately receive assets if beneficiaries predecease the plan owner, under certain default situations, or if specifically named. Review distribution under those circumstances. Also remind your clients of the ability to name trusts and even charities, which were not specifically covered in the article.
But do not get bogged down in the nuances of estate planning. Hypothetical situations could confuse your clients to the point of frustration. Instead, focus on the intent of your client and touch on certain methods of achieving their goal. There is no guarantee that your clients' wishes will be upheld. Someone could die, a will could be invalidated, and so on. Still, your clients will benefit from a review of their designations and its effect on their estate plan.