Other than a house, most people’s largest asset is a retirement account,
such as a traditional IRA or employer 401K plans and similar variations
(403(b) plans for employees of certain tax-exempt organizations and 457(b)
plans for government employees). Retirement accounts receive special treatment
under the tax laws that must be considered while creating an
How Tax Laws Affect Retirement Accounts
As a general rule, special treatment under the tax laws means strict rules
that require strict compliance. The primary concern with retirement accounts
is that distribution from these accounts are subject to income tax even
after the death of the account owner; estates valued over $5.49 million
for a single person may also have certain
estate tax concerns. The rules can get complicated because they differ depending on whether
the account owner had reached the “required beginning date”
– April 1st of the year following the year the individual reaches the age of 70 years
and 6 months.
If the account owner names a spouse as beneficiary on the account, on the
date of the account owner’s death, the surviving spouse can treat
the deceased spouse’s account as his or her own, regardless of whether
the deceased spouse had reached the required beginning date. This process
is known as the “spousal rollover.” If the surviving spouse
has not reached his or her required beginning date, he or she does not
need to take any distributions. This will allow the surviving spouse to
defer paying income taxes until his or her required beginning date.
If the account owner names an individual other than a spouse as beneficiary
on the account, on the date of the death of the account owner, the individual
beneficiary must take distributions from the account. If the account owner
had reached the required beginning date, the individual must take distributions
based on the deceased account owner’s remaining life expectancy
or the individual’s life expectancy if the individual was older
than the account owner. If the account owner had not reached the required
beginning date, the individual must take distributions based on his or
her own life expectancy. This specific process is known as the “stretch
out.” In the case of a large balance in the account, the income
tax hit is reduced because the distributions are stretched out over a
period of years.
When There is No Named Beneficiary
It should be clear that naming a beneficiary on a retirement account is
crucial – but what if the account owner does not name a beneficiary?
In such a case, the account owner’s estate is the beneficiary. If
the account owner had reached the required beginning date, the estate
may take distributions based on the deceased account owner’s remaining
life expectancy. However, if the account owner had not reached the required
beginning date, the estate must take the entire balance by end of fifth
year following the year of the decedent’s passing. The reasoning
behind this rule is that an estate is not an individual and cannot be
a “designated beneficiary” of a retirement account.
For example: With a $1 million retirement account, assuming even distributions of $200,000
per year, that’s $200,000 per year that will be subject to income tax.
Intricacies When Considering Trusts & Retirement Accounts
What if an account owner wants to leave the retirement account in a
trust for minor children? Or perhaps the account owner has older children who
are not good with managing money and wants to create a trust for them?
This is where matters can be quite complicated for those not wholly familiar
with estate planning tax issues.
If drafted correctly, the individuals who are beneficiaries of the trust
will be treated as the designated beneficiaries of the retirement account
and take advantage of the “stretch out” rule. It is important
to be aware of the numerous potential pitfalls, though. For instance,
if one trust beneficiary is much older than the others, it could be seen
as a disadvantage to the younger beneficiaries. If the trust is allowed
to accumulate the retirement distributions, there will be additional requirements.
In the worst case that involves a trust that is drafted incorrectly, the
retirement account will be considered as having no “designated beneficiary”
and be subject to the five-year payout rule as for estates.
Get Help from Our Experienced Attorneys!
Retirement accounts are creatures of the tax law and the rules surrounding
them can become muddled. If you have a large retirement account that you
want to ensure will be handled correctly, let our knowledgeable Longmont
estate planning attorneys at Jorgensen, Brownell & Pepin, P.C. guide
you through the difficult path of planning for retirement accounts. With
decades of combined legal experience, you can trust in our team to keep
your best interests in mind and steer your case to the outcome you desire.
today to request an initial consultation.