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
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.