Estate Planning with IRA’s and 401k’s
One of the most common, and often substantial, assets in a decedent’s estate are Individual Retirement Accounts (“IRAs”) and 401k plan accounts. Under current law, careful thought and planning can extend the life of these retirement accounts for your beneficiaries, and greatly enhance the value of these assets over time.
Traditional IRAs (i.e. not Roth IRAs, which I’ll touch on below) and 401k plans hold pre-tax contributions and tax deferred income and gains earned on those contributions. For IRA’s and 401k’s that you own during your life, you can delay drawing on these accounts until the year after you reach 70 1/2 years of age, which is called the “required beginning date.” At that time, you will need to take annual “required minimum distributions” (“RMDs”) based on IRS tables, and pay taxes on those distributions. So, if you can get by during your 60’s without tapping into your IRA or 401k, that is usually the better strategy to grow your wealth. Likewise, after your death, the best tax strategy is often to “stretch” distributions for your beneficiaries so they can also take full advantage of income tax deferral. The continued deferral of taxes, and compounding of investment gains, can result in substantially more value in the account as compared to the value if funds are withdrawn and taxes are paid sooner.
DESIGNATED BENEFICIARIES
The key to maximizing tax deferral of an IRA or 401k for your family or other beneficiaries is to be sure to properly designate beneficiaries. If you do not designate one or more individuals as beneficiaries, and you die before reaching your required beginning date, then the full amount in your plan must be distributed within five (5) years after your death. If you have not named individual beneficiaries and die after your required beginning date, your heirs can continue to use your age/life expectancy to determine the distribution schedule for your retirement accounts. However if you name one or more individual beneficiaries, regardless of when you die, and regardless of how young the beneficiary is, that beneficiary will be able to use their own age/life expectancy to determine the distribution schedule, so long as a separate, inherited account is established by the end of the year after the year you die.
SPOUSE BENEFICIARIES
Surviving spouse beneficiaries get special treatment under the inherited IRA and 401k rules. First, a spouse beneficiary can delay taking any RMDs until the year after the deceased spouse would have turned 70 1/2 years old. Even better, a spouse beneficiary has the option of rolling over an IRA or 401k into an account, and treating it as their own. This is beneficial because the surviving spouse can then delay RMDs until the year after he/she turns 70 1/2, and the amount of those distributions is determined using a more favorable IRS table than is available to non-spouse beneficiaries. In other words, a spouse beneficiary can maximize delaying RMDs, and once those distributions do start, can take as little out each year as is permitted by the tax laws. Of course, if a surviving spouse needs more than the RMD for a given year, he/she can take more, subject to paying more tax sooner.
NON-SPOUSE BENEFICIARIES
Non-spouse beneficiaries who wish to stretch their distributions and maximize tax deferral are required to take RMDs beginning in the year after the account owner’s death. In order to take full advantage of the rules, an individual beneficiary must have been specifically designated as a beneficiary, and a separate account must be established for that beneficiary by the end of the year after the death of the account owner. If all that is done, the beneficiary may use his/her own age and life expectancy to determine RMDs.
TRUST AS BENEFICIARY
It can be beneficial to establish a trust for a beneficiary, and to designate that trust as the beneficiary of an IRA or 401k. Just as with other assets, holding an IRA or 401k in a trust can protect the asset from creditors, divorce, or situations where a beneficiary might not be able to prudently handle a large, immediate inheritance. But in order to stretch the distributions for an IRA or 401k that is left to a beneficiary in trust, it is essential that the beneficiary designation specifically identify the separate trust of the specific beneficiary, and that the trust provisions adequately address how the retirement account RMDs will be handled by the trustee. The IRS requires that an IRA or 401k be left to an individual, or to a specific trust for the benefit of an individual. So leaving the retirement account to “my estate”, or “my trust”, even when a will or trust attempts to provide for separate, inherited accounts, will not work to maximize tax deferral for the beneficiary.
In addition to getting the beneficiary designation right, the IRA or 401k account owner must decide how the trust will handle RMDs for each, separate trust account. The separate trust could be a “conduit” trust, in which the RMDs are passed along each year to the beneficiary to be taxed as part of the beneficiary’s income. Or, the separate trust could be an “accumulation” trust, in which some or all of the RMDs are retained in the trust until some future time or event. A real disadvantage for an accumulation trust is that any accumulated RMDs will be taxed at the trust tax rates in the year received. The tax table that applies to trusts results in higher taxes than the tax table for individuals, so requiring the trust to pay taxes is not the most tax efficient way to handle this issue. For 2018, trusts pay a 37% tax rate beginning at just $12,500 of income, whereas individuals do not pay tax at that rate until they have over $500,000 of income in a year. But even with this high rate of taxation for trusts, there may be reasons to prefer an accumulation trust over a conduit trust, most likely for the protection of the beneficiary.
ROTH IRAS
Unlike traditional IRAs, Roth IRAs are funded with after-tax contributions, and distributions from Roth IRAs are not taxable to the account owner or beneficiaries so long as they meet certain requirements as to the timing and/or reason for the distribution. There are no RMDs for Roth IRAs during the owner’s lifetime. Inherited Roth IRAs are subject to all of the same RMD rules as traditional IRAs discussed above, except in all cases where a beneficiary is not named, the inherited Roth IRA is treated under those rules as if the account owner died before reaching age 70 1/2. The upshot of this, and really of this whole issue of estate planning with an IRA or 401k, is to make sure all of your retirement accounts have properly designated individual beneficiaries.
POSSIBLE CHANGES IN THE LAW
In 2016, a U.S. Senate committee approved a proposal that would require inherited retirement accounts to be distributed within 5 years of the account owner’s death in all cases where the decedent’s qualified retirement accounts totaled more than $450,000 in the aggregate. The proposal still preserves special rules for spouses, and contains a few other exceptions that would preserve stretch opportunities in some situations. As of September, 2018, apparently the proposal has not gained any traction. But like all tax laws and regulations, current rules are subject to change, and IRA and 401k owners should check in on their estate plans from time to time in order to make sure their plan reflects current law.
