We often get questions about what will happen to a person’s retirement account after they pass. Since one’s retirement account is often one of the largest assets in the estate, passing it to beneficiaries in the most advantageous way possible. Here are five things you need to know about inherited retirement accounts:
Will my beneficiaries have to pay taxes on the inherited retirement accounts I pass to them?
Most likely. Many assets like real estate, vehicles, life insurance and non-retirement investment accounts aren’t counted as income when they are inherited. However, retirement accounts are counted as “income in respect of a decedent”. As such, any funds withdrawn from non-Roth accounts are subject to income tax at the beneficiary’s income tax rate.
Are all retirement accounts treated the same way?
No. Employer sponsored plans, like 401(k) plans and pensions are often subject to additional requirements and limitations than inherited IRAs. Employer sponsored plans often require that the account be totally withdrawn within five years of the account owners death, even if the beneficiary doesn’t want to withdraw the money. All withdrawals are subject to income tax at the beneficiary’s income tax rate.
On the other hand, IRAs nearly always can be “stretched out” over the life expectancy of the beneficiary. This is called a “stretch out” since the beneficiary’s life expectancy is likely longer than that of the IRA account owner. This is a huge advantage for the beneficiary as it will allow for continued tax-deferred growth, thereby reducing the beneficiary’s immediate income tax liability. (Note that many employer sponsored plans effectively end the stretch out by requiring the balance of the inherited IRA to be distributed to the beneficiary when the account owner passes.)
Who should I designate as my beneficiary?
If a person is married they often name their spouse as their primary beneficiary, and their children or other individuals as contingent beneficiaries. If a person is not married, they will name their children, family member(s) or other individuals as their primary beneficiary, making sure to name a contingent beneficiary for the event their beneficiary predeceases them. The upside of this approach is that the IRA will avoid probate proceedings. The downside is that it doesn’t provide any protection or preservation for the inherited retirement accounts. Thus, it is essential that the beneficiary designations on one’s IRA coincides with the owner’s estate planning objectives.
A smarter approach may be to designate a specially designed trust as the beneficiary of the retirement account. By doing so, this can provide ongoing benefits to spouses, children and other beneficiaries. Benefits can include the stretch out as mentioned above, and also protection against the beneficiary’s creditors or potential predators (ex-spouses, etc.).
What are the benefits of using a retirement trust?
For most people, using a trust to pass retirement accounts to beneficiaries provides increased protection and flexibility. When designated to receive retirement account funds, a retirement trust allows the account to continue growing on a tax deferred basis for as long as possible, and distributed according to the deceased person’s wishes. In addition, it protects the inherited funds from the beneficiary’s creditors or predators.
Because of the income tax treatment of inherited retirement accounts, retirement accounts must be carefully drafted. If improperly drafted, the entire inherited account balance could be required to pay out within five years of the account owner’s death. If that happened, the long term tax deferred growth of the funds would be lost. The beneficiaries would also end up with an income tax bill for the distributions. In addition, the distributed funds would be subject to the claims of the beneficiary’s creditors or predators.
How do I get started?
We can review your retirement plan’s documentation and work with you to ensure the fund in the account are passed in a way that’s consistent with your overall estate planning objectives. We can also help ensure that beneficiary designations are correctly stated and set up a retirement trust if desired. Call Scottsdale trust attorney Abigail Neal at (480) 699-7992 today to discuss how your retirement plan fits in to your estate planning goals.