Estate Planning and Retirement Accounts

Posted By Jorgensen, Brownell & Pepin, P.C.

26 Jan. 2016

For many people, their largest asset aside from their home is their retirement account, whether an Individual Retirement Account (IRA) or a 401K. For people who have diligently made contributions, these accounts can easily reach $1 million or more. Fortunately, the federal estate tax does not kick in until an estate is worth just over $5 million ($5.45 million for 2016, indexed for inflation each year). So, a $2 million 401K account generally does not pose an estate tax problem, unless Congress changes the law. However, the problem with retirement accounts is that they are still subject to income tax once the owner dies. If the owner is survived by a spouse, the problem is not as complicated. If the owner does not have a surviving spouse, the rules can get complicated.

The “Stretch Out”

If a beneficiary takes the entire value of a retirement account as a lump sum distribution, the beneficiary must pay income tax on the distribution. For retirement accounts worth hundreds of thousands of dollars, the tax bite can be substantial. The goal in planning for large retirement accounts is to have the distributions “stretched out” over a beneficiary’s life expectancy. This allows the income tax to be deferred over the beneficiary’s lifetime. However, if a beneficiary is not named on the retirement account, the tax rules state that the beneficiary is the deceased owner’s estate. Since an estate is not a natural person with a life expectancy, the entire retirement account must be completely distributed within 5 years. While better than a lump sum distribution, it is clearly not as advantageous as stretching out the distributions over a 20 year period. So, at a minimum, retirement accounts should have a named beneficiary.

What About Trusts?

Trusts are a great way to manage money for a beneficiary who is a minor, may need help managing money, or just needs some additional protection for his or her assets. But like an estate, a trust is not a natural person with a life expectancy. However, the tax rules allow for a trust to be named as a beneficiary of retirement accounts and still qualify for the stretch out rules if certain requirements. If the requirements are not meant, the retirement account must be distributed within 5 years. These requirements are very specific and not simple. If you want a trust to be able to accumulate the distributions and leave it up to the trustee to determine when a beneficiary should receive funds, the rules get very complicated.
Proper Planning Can Mean Big Tax Savings
Type “estate planning forms” into any search engine and you will probably find plenty of sites for do-it-yourself estate planning. But even the unique issues and complicated rules involved with retirement accounts, planning for such accounts is not an easy do-it-yourself project that can be finished in one weekend. It’s one thing to paint a house and quite another to redo all of the electrical wiring. Let us help you correctly wire your retirement benefits so your beneficiaries aren’t “shocked” by bad tax consequences.

Categories: Estate Planning
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