Estate Planning for Your Retirement Accounts

Traditional IRA’s, 401(k)’s, Tax Qualified Annuities, and other tax deferred accounts often make up, along with a home, the majority of many Americans’ assets. When putting together an estate plan, it is essential to review the accounts and determine the best way to leave them to loved ones. Today’s blog posts will go over the nuts and bolts of estate planning with tax deferred accounts.

What is a Tax Deferred Retirement Account?

A tax deferred retirement account is a financial account where your contributions can grow tax deferred until they are withdrawn. Traditional IRAs, 401(k)’s, and some annuities are tax deferred. In short, with a tax deferred account, you don’t pay income tax on money you put into them. They are able to grow tax free and eventually, when you pull the money out, you will need to pay income tax on those distributions.

Should You Choose a Trust or Individual Beneficiaries to Received Your Tax Deferred Account?

There are some good reasons to consider naming a trust as a beneficiary of your tax deferred accounts.

• A trust can protect the funds from creditors and the poor choices of the beneficiary if, for example your beneficiary is irresponsible with money or has creditor problems due to age or inexperience, substance abuse, a gambling problem, etc.
• A trust can ensure that the funds are used for a particular purpose like education, or that the funds are disbursed over a determined period of time.
• A trust can protect your beneficiary’s eligibility for government benefits like Medicaid and/or SSI, while also giving them the benefit of the inheritance.

There are also some good reasons to leave tax deferred accounts directly to beneficiaries.

• If your beneficiaries are responsible with money and don’t need oversight, beneficiary designations are simple, cost effective and can be changed easily.

Choosing whether to have tax deferred accounts go directly to beneficiaries or a Trust should be made as part of a coherent estate plan put in place with the guidance of an Estate Planning Attorney.

How Do I Put Beneficiary Designations on My Tax Deferred Account?

Financial institutions all have their own forms and rules for designating a beneficiary of a tax deferred account. It is essential that you contact your financial institution to ensure that you follow the rules and complete the forms correctly so that your wishes are carried out. Without a properly completed beneficiary designation, the account will transfer by way of the rules of the financial institution, your Last Will and Testament or your state’s inheritance laws.

What Happens When an Individual Beneficiary Is Named?

A non-spouse beneficiary has two options once she inherits a tax deferred retirement account. First, she can have the value of the account distributed to her as a lump sum. If she chooses this first option, she will have to pay income tax on the full value of the distribution she receives. This can bump her into a higher tax bracket and result in a significant income tax liability.

Second, she can retitle the account in the name of the deceased IRA owner for the benefit of herself. The IRA will continue to grow tax deferred. Under the Secure Act, designated beneficiaries (with the exception of eligible designated beneficiaries) have 10 years, starting the year following the owner’s death, to distribute all the funds.

The Secure Act, which passed in 2020, eliminated the ability of all beneficiaries to stretch out distributions based upon their life expectancies. Now, only eligible designated beneficiaries, that is spouses, chronically ill, disabled persons, beneficiaries less than 10 years younger than the account owner, and minor children until they become adults, may stretch out distributions based on the life expectancy of the beneficiary.

A spouse has an additional option. She can roll over an inherited deferred tax retirement account into her own IRA or other tax deferred plan and delay taking minimum distributions until she reaches the age of 70 ½. This can be advantageous if the spouse wishes to delay distributions until she is in a lower tax bracket.

What Happens with Multiple Beneficiaries Are Named?

As long as it is permitted by the financial institution, an owner of an IRA can name multiple beneficiaries and upon death, the IRA will be split into separate IRAs for each of the beneficiaries.

What Happens When a Trust is Named the Beneficiary?

Under IRS rules and the Secure Act, if an account owner names a trust as a beneficiary of an IRA, there are three possible outcomes. First, all distributions from the account must be made to the trust within five years of the owner’s death. This is the likely outcome if the trust was not drafted specifically for the purpose of receiving a tax deferred account. Second, if the trust was drafted to received tax deferred accounts for an eligible designated beneficiary (as stated above, that is spouses, chronically ill, disabled persons, beneficiaries less than 10 years younger than the account owner, and minor children until they become adults), distributions must be made into the trust based on the life expectancy of the beneficiary. Third, if the trust was drafted to receive tax deferred accounts for an eligible beneficiary (that is everyone that isn’t a designated beneficiary as listed above), distributions must all be made into the trust within 10 years of the account owner’s death.

For income tax reasons, it is generally preferably to stretch out distributions for as many years as possible. Hence, if a trust will be named beneficiary of a tax deferred account, it is important that the trust was drafted for that specific purpose.

For more information on Estate Planning for Tax Deferred Retirement Accounts, speak to a Cleveland Estate Planning lawyer.