As retirement accounts, including 401(k), 403(b), IRAs and Roth IRAs, have become the dominant way to save for retirement, they may make up an increasingly large share of a family’s assets. Because of this, retirement accounts are one of the more important parts of an estate plan. Due to the special tax treatment of retirement accounts, many ordinary planning techniques, including Wills and Living Trusts, cannot be used to directly control their disposition.
Before proceeding further, we will review the basics of the most common types of retirement accounts. Employer-provided retirement accounts (401(k) plans provided by for-profit companies, and 403(b) plans provided by not-for-profit companies) are largely subject to the same rules. These plans allow an employee to make contributions to the plan before taxes are paid. The employer may, but is not required to, provide a matching contribution. Federal law also provides protection for the employee’s spouse by requiring the spouse provide consent for the employee to name someone else as the beneficiary. Once the account owner reaches age 55 (or qualify under several other limited exceptions), they may make withdrawals that are taxed as ordinary income.
Individual Retirement Accounts (IRAs) are not employer sponsored, but are similar to 401(k) plans in that the money contributed to an account is not taxed, but the withdrawals are taxed as ordinary income. In contrast, income contributed to Roth IRAs is taxed, but withdrawals after reaching age 55, or are otherwise eligible, are not taxed. Employers providing 401(k) or 403(b) plans may also provide an option to make Roth- type contributions as a part of their plan. In the remainder of this article, 401(k), 403(b), and IRA accounts will be referred to as pre-tax retirement accounts, and Roth IRA and Roth 401(k) accounts will be referred to as post-tax accounts.
What all retirement plans have in common is that their transfer at the owner’s death is governed by beneficiary designations. Unless the account owner designates their estate or trust as the beneficiary, or there is no surviving named beneficiary, and by the account’s rules, the default beneficiary is the owner’s estate. A will or trust does not direct the disposition of the account. Because of their tax status, none of the retirement accounts discussed in this article may be transferred to a Living Trust without the transfer being considered a taxable distribution. Furthermore, the relationship between the account owner and beneficiary determines when the beneficiary must withdraw funds from the account.
If a spouse is named as the beneficiary of a pre-tax retirement account, the spouse receives preferential treatment. The beneficiary spouse may take ownership of the account, and it is treated as if they were the original owner. The spouse is only subject to the Required Minimum Distribution (RMD) rules which require they take distributions starting at age 73 (and starting in 2025, age 74). Other persons who are beneficiaries must withdraw all funds from the account within ten years, subject to exceptions for beneficiaries who are minors or who are less than ten years younger than the original owner. Beneficiaries who are not individual persons are generally subject to different, and less favorable, treatment.
Designating a minor or a legally disabled person (the definition of a legally disabled person is distinct from definitions of disability used for determination of eligibility for Social Security or other benefits, and requires that the person lacks the intellectual capacity to manage their personal or financial affairs) as the beneficiary of a pre-tax retirement account presents special challenges because they do not have the actual or legal capacity to receive the gift directly. If a minor or legally disabled person is directly named as beneficiary, the account will be subject to court supervision through the appointment of a guardian to control the account. If a trust for the benefit of the minor or legally disabled person is named as beneficiary, and proper care is not taken, the entire account can be taxed at once, and in some circumstances at the higher rates for trust or estates, rather than being allowed to be withdrawn over ten years. If a trust is named as beneficiary, the tax treatment of the account is subject to complex and time sensitive requirements regarding the identification of the ultimate beneficiary of the account, and whether the IRS will treat the trust as the beneficiary, or “see through” the trust and treat the ultimate beneficiary as the beneficiary for tax purposes. Because of these complexities, we recommend that if you wish for a minor, legally disabled person, or trust to be the ultimate beneficiary of your pre-tax retirement account, you should consult with an attorney experienced in estate and tax planning to avoid any unintended tax or other consequences.
If you wish to make charitable gifts as a part of your estate plan, pre-tax retirement accounts present opportunities for tax savings. If a pre-tax retirement account is transferred to a qualified charity, then the charity may make the withdrawals without being subject to tax. A gift of a pre-tax retirement account to a charity may be done by either directly naming the charity as the beneficiary, or by naming an estate or Living Trust as the beneficiary and incorporating provisions that allow for the executor or successor trustee to make a charitable gift using pre-tax retirement accounts.
During your lifetime, you may satisfy your obligation to make Required Minimum Distributions by making tax-free distributions directly from your pre-tax retirement accounts to a qualified charity. Having the financial institution making the payment directly to the qualified charity effectively allows you to take a charitable contribution deduction while not itemizing deductions on your tax return.
Beneficiaries of post-tax accounts are subject to different rules. Unless the beneficiary is the spouse, minor child, or is less than ten years younger than the original owner, or is disabled (not necessarily legally disabled) or chronically ill, then the beneficiary must fully distribute the account within ten years. The distributions do not result in payment of taxes, but result in any further investment gains being subject to taxation. If the sole beneficiary of the account is the spouse of the original owner, then the spouse may treat the account as if they were the original owner. Beneficiaries who are disabled, chronically ill, or less than ten years younger than the original account owner must take minimum distributions based on their life expectancy, or within five years, they must withdraw all funds from the account, beginning the later of when the original account holder would have been required to taking RMDs, or
December 31 of the year following the original owner’s death. If there are multiple beneficiaries, minimum distributions are calculated based on the life expectancy of the oldest beneficiary. All of these rules only establish minimum distributions, and a beneficiary may withdraw larger amounts if they wish to do so.
Retirement accounts may be the most valuable asset a person owns, and as such, are a vital consideration for estate plans. Since they receive preferential tax treatment, they are subject to complex requirements that may have a significant impact on your estate plan. While the designation of a beneficiary may seem like a simple matter, there are potentially significant complications and pitfalls if there is an improper designation. Careful consideration and expert advice that the attorneys at Plager, Krug, Bauer, Rudolph & Stodden, Ltd. may provide are essential to avoiding these pitfalls and maximizing the benefit of your assets for your beneficiaries.