Estate Planning Tips for IRAs & 401(k)s

If you have a family, chances are that the vast majority of your assets are held in one of two ways:  your home, and your tax-deferred retirement account, such as an Individual Retirement Account (IRA) or 401(k).  While estate planning for a home is relatively straight-forward, estate planning for retirement accounts is anything but.

First, the inheritance of your retirement account is governed by beneficiary designation – not by the terms of your will.  If your will differs from what’s on the beneficiary designation form, the beneficiary designation form will trump your will, so it’s important to keep your beneficiary designations up-to-date.

Second, options for continuing a 401(k) account may vary, depending on the administrator of the retirement plan.  Some plan administrators will allow surviving spouses or other beneficiaries to continue the account; however, others will require that the account be transferred to an IRA.

By far, the most challenging aspect of estate planning for tax-deferred retirement accounts involves how these assets are taxed.  In order to understand the complex rules applicable to inherited tax-deferred accounts, it’s necessary to first understand the general rules governing these assets.

Rules Governing Tax-Deferred Retirement Accounts

Income that is contributed to a tax-deferred retirement account is not subject to income tax when you earn it.  Instead, income contributed to such an account is taxed when the funds are withdrawn – which typically happens in retirement.  This provides two advantages from a tax perspective.  First, it allows investment earnings to accumulate on pre-tax dollars, providing a larger amount of your earnings to grow free of tax until the funds are withdrawn.  Second, because you are likely to be in a lower tax bracket in your retirement, the withdrawals may be subject to a lower tax rate than they would have been if the money had been taxed at the time it was earned.

In order to deter taxpayers from using tax-deferred accounts for purposes other than retirement, there is a penalty for withdrawing funds earlier than age 59 ½.  Conversely, in order to prevent tax-payers from using these accounts to accumulate tax-free wealth for future generations, the government requires that you begin withdrawing funds from these accounts when you reach age 70 ½.  At that time, you must start taking what are called “Required Minimum Distributions” (RMDs) from your account each year.

The amount of the required distribution is based on your life expectancy as determined by IRS regulations.  Roughly speaking, the amount of your required distribution each year is the total value of your account divided by your life expectancy.  For example, if you turn 71 years old with a retirement account of $1 million and have a 20 year life expectancy, you would be required to withdraw from your account at least $50,000 in that year.  Any amounts withdrawn are taxed at your individual income tax rate.

Taxation of Inherited Retirement Accounts

All of this background information is necessary to understand the web of rules that govern the taxation of an inherited retirement account.  If the owner of a tax-deferred account dies, because the money in the account has not been subject to income tax, the government taxes it under various rules, depending on who inherits the account and when withdrawals are made.

There are special rules applicable to accounts inherited by a spouse.  An inheriting spouse can roll an account over into her own IRA, which means the surviving spouse can defer taking distributions until he or she reaches age 70 ½.

Aside from spouses, there are two other categories of beneficiaries:  “qualified beneficiaries” and “non-qualified beneficiaries.”  Qualified beneficiaries are limited to individual taxpayers, while non-qualified beneficiaries include estates and most types of trusts.

Retirement accounts left to “qualified beneficiaries” can be extended for the life of the beneficiary, in what is sometimes called an inherited or “stretch” IRA.  In this scenario, the beneficiary is subject to RMDs and must begin taking distributions in the year following the death of the account owner.  The distributions are taxable income to the beneficiary at his or her individual income tax rate.

The amount of RMDs for an inherited IRA is based on the life expectancy of the beneficiary – not the former owner of the account.  As a result, accounts left to children can provide significant tax-deferral benefits.  For example, suppose a 20 year old inherits his father’s $1 million 401(k).  If his life expectancy is 100 years, he can “stretch” the tax-deferral benefits of the account far beyond the life expectancy of his father.  If the money is needed earlier, he can always withdraw more than the minimum distribution.

The IRS treats “non-qualified beneficiaries” far less generously.  The transfer of a tax-deferred account to a non-qualified beneficiary is deemed to be a withdrawal of all the funds in the account, triggering income tax on the entire amount.  This event eliminates any tax-deferral benefit and potentially results in taxation at a much higher tax rate, since the entire amount is taxed in the same year.  For example, if a $1 million tax-deferred account is taxable in one year, it will be subject to the highest marginal tax rate.  In contrast, if the $1 million can be withdrawn and taxed over a 20 year period, only $50,000 would be subject to tax in any one year, at potentially half the tax rate that would have applied if the entire $1 million was taxed in the same year.

For this reason, it is generally ill-advised to leave a retirement account to your estate or to most types of trusts.  When you have young children, however, leaving assets to them directly can result in a host of problems, including costly and intrusive court supervision, lack of privacy, unwise spending at a young age, and – if you have more than one child – an inability to adjust assets in response to children’s differing needs.

The IRA Trust

While most trusts are “non-qualified beneficiaries,” a certain type of trust, if drafted correctly, preserves the tax-deferral benefits of the retirement account while providing the protection of a trust.  This kind of trust is sometimes called an IRA Trust.

In an IRA Trust, the IRS will look through the trust to the trust’s beneficiaries and calculate RMDs based on the age of the oldest trust beneficiary.  For example, if you leave your tax-deferred retirement accounts to an IRA Trust for the benefit of your two children, and you pass away when one child is 13 and the other is 15, the trust must take RMDs for the account will be calculated based on the life expectancy of the 15-year-old.  The trust could make additional withdrawals from the accounts as needed for the children.  If the IRA Trust terminates when the youngest child reaches age 30, the retirement account will divide into two separate Inherited IRAs – one for each child –  preserving the tax-deferral benefits until the accounts have been depleted.

Custodianship

If you don’t have substantial assets in your retirement accounts, it may not be worth it to pay a lawyer to draft an IRA Trust.  In that case, you may wish to leave your retirement accounts to your minor children in the form of a custodianship.  A custodianship avoids court supervision and public reporting of the account, while allowing you to choose a close friend or family member to administer the funds.  Your children would generally receive unrestricted access to the accounts at the age of 18.

Unlike a trust, retirement account funds left to children through a custodianship cannot be held in a common vehicle.  For example, with a trust, the trustee can make distributions to any of your children as your appointed trustee deems fit.  With a custodianship, assets must be left to children individually, and assets left to one child cannot be used for the benefit of his or her sibling.

For tax purposes, retirement accounts left to a child through a custodianship are treated as if they were left to the child directly.  Therefore, RMDs are calculated based on the life expectancy of the child.  For instance, you might name as beneficiary “my children equally, to be held by Jane Doe as custodian for each child who is under the age of 18 at the time of my death.”  If you died with two children, one 10 and the other 15, your account would be divided into two separate IRAs, one for each child.  RMDs for each child’s Inherited IRA would be calculated based on that child’s age.

If you wish to leave assets in a custodianship for your minor children, contact your plan administrator.  They should be able to advise you on what language to use in filling out your beneficiary designation form.

About the Author

Shannon McNulty

Shannon McNulty is the founder of Savvy-Parents.com and a lawyer in New York City who provides legal planning for parents with young children. Shannon received her J.D. from Georgetown University Law Center and her LL.M. in Taxation from NYU School of Law. She has also earned her CERTIFIED FINANCIAL PLANNER(TM) designation. You can learn more about Shannon and her firm at www.cityparentslaw.com.

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