Estate Planning for Large Retirement Accounts

Other than a house, most people’s largest asset is a retirement account, such as a traditional IRA or employer 401K plans and similar variations (403(b) plans for employees of certain tax-exempt organizations and 457(b) plans for government employees). Retirement accounts receive special treatment under the tax laws that must be considered while creating an estate plan.

How Tax Laws Affect Retirement Accounts

As a general rule, special treatment under the tax laws means strict rules that require strict compliance. The primary concern with retirement accounts is that distribution from these accounts are subject to income tax even after the death of the account owner; estates valued over $5.49 million for a single person may also have certain estate tax concerns. The rules can get complicated because they differ depending on whether the account owner had reached the “required beginning date” – April 1st of the year following the year the individual reaches the age of 70 years and 6 months.

If the account owner names a spouse as beneficiary on the account, on the date of the account owner’s death, the surviving spouse can treat the deceased spouse’s account as his or her own, regardless of whether the deceased spouse had reached the required beginning date. This process is known as the “spousal rollover.” If the surviving spouse has not reached his or her required beginning date, he or she does not need to take any distributions. This will allow the surviving spouse to defer paying income taxes until his or her required beginning date.

If the account owner names an individual other than a spouse as beneficiary on the account, on the date of the death of the account owner, the individual beneficiary must take distributions from the account. If the account owner had reached the required beginning date, the individual must take distributions based on the deceased account owner’s remaining life expectancy or the individual’s life expectancy if the individual was older than the account owner. If the account owner had not reached the required beginning date, the individual must take distributions based on his or her own life expectancy. This specific process is known as the “stretch out.” In the case of a large balance in the account, the income tax hit is reduced because the distributions are stretched out over a period of years.

When There is No Named Beneficiary

It should be clear that naming a beneficiary on a retirement account is crucial – but what if the account owner does not name a beneficiary? In such a case, the account owner’s estate is the beneficiary. If the account owner had reached the required beginning date, the estate may take distributions based on the deceased account owner’s remaining life expectancy. However, if the account owner had not reached the required beginning date, the estate must take the entire balance by end of fifth year following the year of the decedent’s passing. The reasoning behind this rule is that an estate is not an individual and cannot be a “designated beneficiary” of a retirement account.

For example: With a $1 million retirement account, assuming even distributions of $200,000 per year, that’s $200,000 per year that will be subject to income tax.

Intricacies When Considering Trusts & Retirement Accounts

What if an account owner wants to leave the retirement account in a trust for minor children? Or perhaps the account owner has older children who are not good with managing money and wants to create a trust for them? This is where matters can be quite complicated for those not wholly familiar with estate planning tax issues.

If drafted correctly, the individuals who are beneficiaries of the trust will be treated as the designated beneficiaries of the retirement account and take advantage of the “stretch out” rule. It is important to be aware of the numerous potential pitfalls, though. For instance, if one trust beneficiary is much older than the others, it could be seen as a disadvantage to the younger beneficiaries. If the trust is allowed to accumulate the retirement distributions, there will be additional requirements. In the worst case that involves a trust that is drafted incorrectly, the retirement account will be considered as having no “designated beneficiary” and be subject to the five-year payout rule as for estates.

Get Help from Our Experienced Attorneys!

Retirement accounts are creatures of the tax law and the rules surrounding them can become muddled. If you have a large retirement account that you want to ensure will be handled correctly, let our knowledgeable Longmont estate planning attorneys at Jorgensen, Brownell & Pepin, P.C. guide you through the difficult path of planning for retirement accounts. With decades of combined legal experience, you can trust in our team to keep your best interests in mind and steer your case to the outcome you desire.

Contact us today to request an initial consultation.