For many Americans, retirement accounts comprise a substantial portion of their personal wealth. When planning your estate, it is important to consider the ramifications of tax-deferred retirement accounts, including 401(k) and 403(b) accounts, SEP-IRAs and traditional IRAs.
Roth IRAs are not tax-deferred accounts and are therefore treated differently. I’ll discuss the estate planning implications of Roth IRAs in an upcoming post.
Required Minimum Distributions (RMDs)
One of my clients’ primary goals is to pass their assets to their beneficiaries in a way that enables them to pay the lowest possible tax. Although inherited property is generally not subject to income tax, that is not the case with tax-deferred retirement accounts, which represent money on which the government has not previously collected income tax. Money cannot be kept in an IRA indefinitely; it must be distributed according to federal regulations, and the beneficiaries will be taxed on the distributions as regular income. The amount that must be distributed annually is known as the required minimum distribution (RMD). If the distributions do not equal the RMD, beneficiaries may be forced to pay a 50% excise tax on the amount that was not distributed as required.
Beneficiary Distributions and Tax Implications
After death, the beneficiaries typically will owe income tax on the amount withdrawn from the decedent’s retirement account. Beneficiaries must take distributions from the account based on the IRS’s life expectancy tables, and these distributions are taxed as ordinary income. If there is more than one beneficiary, the one with the shortest life expectancy is the designated beneficiary for distribution purposes. Sound estate planning techniques can afford the beneficiaries a way to defer this income tax for as long as possible by delaying withdrawals from the tax-deferred retirement account.
Spousal Beneficiaries
The most tax-favorable situation occurs when the decedent’s spouse is the named beneficiary of the account. The spouse is the only person who has the option to roll over the account into his or her own IRA. In doing so, the surviving spouse can defer withdrawals until he or she turns 70 ½; whereas any other beneficiary must start withdrawing money the year after the decedent’s death.
Trusts as Beneficiaries
Generally, a revocable trust should not be the beneficiary of a tax-deferred retirement account, as this situation limits the potential for income tax deferral. A trust may be the preferred option if a life expectancy payout option or spousal rollover are unimportant or unavailable, but this should be discussed in detail with an experienced estate planning attorney. Additionally, there are situations where income tax deferral is not a consideration, such as when an IRA or 401(k) requires a lump-sum distribution upon death, when a beneficiary will liquidate the account upon the decedent’s death for an immediate need, or if the amount is so small that it will not result in a substantial amount of additional income tax.
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The bottom line is that trusts typically should be avoided as beneficiaries of tax-deferred retirement accounts, unless there is a compelling non-tax-related reason that outweighs the lost income tax deferral of using a trust. This is a complex area of law involving inheritance and tax implications that should be fully considered with the aid of an experienced estate planning lawyer.