By Matthew T. McClintock, J.D.
Vice President, Educational Content, WealthCounsel
Almost everyone has some kind of retirement account—whether a 401(k), IRA or pension—so proper estate planning for these funds is essential. From tax treatment to beneficiary designations, Matthew T. McClintock, J.D., VP of Education with WealthCounsel, answers your questions.
Will my beneficiaries owe taxes on the retirement accounts I pass down to them?
Probably. Assets like life insurance, real estate, vehicles and non-retirement investment accounts are not counted as income when they’re inherited. Retirement accounts, however? They’re “income in respect of a decedent,” and any amounts withdrawn from non-Roth accounts are subject to income tax at the beneficiary’s ordinary income tax rate.
Are all retirement accounts treated the same way?
No. Beneficiaries who are left employer-sponsored plans, like 401(k)s and pensions, are often subject to more limitations and requirements than those who inherit IRAs.
Often, the employer-sponsored plan will require account withdrawal within five years of the account owner’s death, even if the beneficiary doesn’t need or want to withdraw money from the account. All withdrawals by the beneficiary are subject to income tax.
IRAs, by contrast, can almost always be stretched out over the life expectancy of the beneficiary, allowing continued tax-deferred growth in the account and reducing the beneficiary’s immediate tax liability. (Note that many employer-sponsored plans require the balance to be distributed to an inherited IRA when the account owner dies, effectively extending the “stretch out” treatment to those accounts.)
Who should I designate as my beneficiary?
Many people name their spouse as their primary beneficiary and then designate their children or other individuals as contingent beneficiaries. While this approach will usually avoid probate proceedings, it doesn’t provide any level of preservation or protection for the inherited accounts. It’s also essential to make sure that the beneficiary designations match the individual’s broader estate planning objectives.
The smarter approach? Often, it makes more sense to leave the retirement account to a carefully designed trust, which can provide ongoing benefits to spouses, children and other beneficiaries. Holding the account in a trust also provides protection against beneficiaries’ creditors.
Why should I use a trust? Is it risky?
In most cases, passing a retirement account to beneficiaries via a trust provides an increased level of protection and flexibility. A trust that is specifically designed to receive retirement account balances allows the account to continue growing, on a tax-deferred basis, for as long as possible. It also protects the inherited balance from the beneficiary’s creditors and allows for distribution in accordance with the deceased account holder’s wishes.
However, due to the income tax treatment of inherited retirement accounts, retirement trusts must be carefully drafted. If set up incorrectly, a trust could require the entire inherited account balance to be paid out within five years of the account owner’s death. In that case, long-term, tax-deferred growth of the funds would be lost, and beneficiaries would be faced with a substantial (and unexpected) income tax bill.
Additionally, the funds would be subject to the claims of any of the beneficiaries’ bankruptcy or judgment creditors.
How do I get started?
Your estate planning attorney can review your retirement plan’s documentation and work with you to make sure the account is distributed in a way that’s consistent with your overall estate planning objectives. A good attorney can also help ensure that beneficiary designation forms are written correctly and, if needed, help to properly set up a retirement trust.
Disclaimer Notice: It is my intention that the comments, articles, and other information provided on this website are intended to provide you with general information which may be interesting and of value to you. You should not construe any of this information as legal advice or my opinion as it may relate to your specific circumstances. Please feel free to contact me directly if you would like to discuss your own situation and your estate or business planning needs.